Running head: CRITICAL THINKING 7 1
Critical Thinking 7
Ben Yellets
Liberty University
Global Economic Environment
BUSI 620
Dr. Duda
April 24, 2014
CRITICAL THINKING 7 2
DQ 14-12. What is the rationale behind the minimax regret rule? What are some
less formal and precise methods of dealing with uncertainty? When are these useful?
The rationale behind the minimax regret rule is to minimize the risk associated with
business decisions and reduce the regret from those decisions. The regret associated with each
decision is measured by subtracting the payoff from that decision from the maximum payoff
under the same state of nature. The decision maker then chooses the strategy with the minimum
of theses maximum regrets under any possible state of nature. Some of the less formal and
precise methods of dealing with uncertainty are as follows:
1. Acquisition of additional information - this can go a long way in reducing the
uncertainty surrounding a particular strategy or event and the dangers arising from it,
but is very costly.
2. Requesting the opinion of a particular authority – requests could be made to the IRS
on tax questions, the Labor Relations Boards on labor questions, and Securities and
Exchange Commission on financial investments.
3. Trying to control the business environment in which they operate – the is done by
firms attempting monopoly control by means of patents, copyrights, and exclusive
franchises.
4. Diversification in the types of products produced, in the composition of security
portfolios, and in different lines of business by conglomerate corporation.
CRITICAL THINKING 7 3
DQ 14-15. How does the adverse selection problem arise in the credit-card market?
How do credit-card companies reduce the adverse selection problem that they face? To
what complaint does this give rise?
Adverse selection is when low-quality products or services drive high-quality products or
services out of the market as a result of asymmetric information between buyers and sellers.
Credit card companies are more likely to attract more borrowers who either do not repay their
debts or repay them late. This creates an adverse selection problem and increases interest rates.
This draws more bad borrowers and would raise interest rates so high that it would not even
make sense for these bad borrowers to use credit cards.
To reduce this adverse selection problem, credit card companies share borrower’s credit
histories with other credit card companies. This brings out the issue of invasion of privacy. That
is a valid point, but without the sharing of this information credit card companies would have to
charge much higher interest rates.
SP 14-1. An individual has to choose between investment A and investment B. The
individual estimates that the income and probability of the income from each investment
are as given in the following table: (a) Using Excel’s statistical tools, calculate the standard
deviation of the distribution of each investment. (b) Which of the two investments is more
risky? (c) Which investment should the individual choose?
Investment
A
Income
Probabilit
y
Expecte
d
Income
Deviatio
n
Deviation
Squared
Deviation
Squared*Prob
ability
4000 0.2 800 -1500 2250000 450000
5000 0.3 1500 -500 250000 75000
CRITICAL THINKING 7 4
6000 0.3 1800 500 250000 75000
7000 0.2 1400 1500 2250000 450000
5500 Variance 1050000
Standard
Deviation 1024.695077
Investment
B
Income
Probabilit
y
Expecte
d
Income
Deviatio
n
Deviation
Squared
Deviation
Squared*Prob
ability
4000 0.3 1200 -2000 4000000 1200000
6000 0.4 2400 0 0 0
8000 0.3 2400 2000 4000000 1200000
6000 Variance 2400000
Standard
Deviation 1549.193338
(a) The standard deviation for Investment A is $1,024.70 and $1,549.19 for Investment
B.
(b) Investment B is a more risky than Investment A because it have a higher standard
deviation.
(c) From the information provided, it is unclear to which investment the individual
should choose. It depends on if the investor would be will to accept less of a profit
with Investment A. By choosing Investment A the individual would assume less risk,
but in return lose out on a chance of greater profit.
SP 14-2. An individual is considering two investment projects. Project A will return
a zero profit if conditions are poor, a profit of $4 if conditions are good, and a profit of $8 if
conditions are excellent. Project B will return a profit of $2 if conditions are poor, a profit
of $3 if conditions are good, and a profit of $4 if conditions are excellent. The probability
distribution of conditions is as follows: (a) Using Excel, calculate the expected value of each
project and identify the preferred project according to this criterion. (b) Assume that the
individual’s utility function for profit is U(X) = X – 0.05X^2. Calculate the expected utility
CRITICAL THINKING 7 5
of each project and identify the preferred project according to this criterion. (c) Is this
individual risk adverse, risk neutral, or risk seeking? Why?
Project
A
State of
Nature
Probabilit
y Profit
Expecte
d Profit
Associate
d utility
Ex
pe
cte
d
util
ity
Poor 0.4 0 0 0 0
Good 0.5 4 2 3.2
1.
6
Excelle
nt 0.1 8 0.8 4.8
0.
48
2.8
2.
08
Project
B
State of
Nature
Probabilit
y Profit
Expecte
d Profit
Associate
d utility
Ex
pe
cte
d
util
ity
Poor 0.4 2 0.8 1.8
0.
72
Good 0.5 3 1.5 2.55
1.
27
5
Excelle
nt 0.1 4 0.4 3.2
0.
32
2.7
2.
31
5
(a) Project A is the preferred project because the expected profit of 2.8 is greater than the
2.7 expected profit from Project B.
(b) Under this criterion, Project B would be the better choice because the utility expect is
2.315 compared to only 2.08 of Project A.
CRITICAL THINKING 7 6
(c) The individual is risk adverse because the utility function of profit increases at a
decreasing rate or faces down so that the marginal utility of profit diminishes.
DQ 15-7. (a) When can the NPV and the IRR methods of evaluating investments
projects provide contradictory results? (b) How can this arise? (c) Which method should
then be used? Why?
(a) NPV and IRR methods can provide contradictory results when evaluating mutually
exclusive investment projects. They will always provide the same result on a single
or independent project.
(b) The NPV and IRR methods can provide contradictory investment signals because the
NPV method implicitly and conservatively assumes that the net cash flows generated
by the investment project are reinvested at the firm’s cost of capital or risk-adjusted
discount rate, while the IRR method implicitly assumes that the net cash flows
generated by the investment project are reinvested at the same higher IRR earned on
the given project.
(c) When contradictory signals are provided, the firm should use the NPV result because
they are not guaranteed they would be able to reinvest the net cash flow from the
project at the same higher IRR earned on the project.
P 15-8. John Piderit, the general manager of the Western Tool Company, is
considering introducing some new tools to the company’s product line. The top
management of the firm identified three types of tools (referred to as projects A, B, and C).
The various divisions of the firm have provided the data given in the following table on
these three possible projects. The company has a limited capital budget of $2.4 million for
CRITICAL THINKING 7 7
the coming year. (a) Which project(s) would the firm undertake if it used NPV investment
criterion? (b) Is this the correct decision? Why?
(a)
The NPV of Project A = $3,000,000 – $2,400,000 = $600,000
The NPV of Project B = $1,750,000 – $1,300,000 = $450,000
The NPV of Project C = $1,400,000 - $1,100,000 = $300,000
The firm has two options, it could go with project A or projects B and C. The best option
for the firm is to undertake project B and C because the NPV is $750,000 compared to only
$600,00 for project A.
(b) This is the correct decision because projects B and C provide a higher rate of return
per dollar invested. This is shown using profitability index.
Project A, PI = $3,000,000/$2,400,000 = 1.25
Project B, PI = $1,750,000/$1,300,000 = 1.35
Project C, PI = $1,400,000/$1,100,000 = 1.27
P 15-10. The MacBurger Company, a chain of fast-food restaurants, expects to earn
$200 million after taxes for the current year. The company has a policy of paying out half
of its net after-tax income to the holders of the company’s 100 million shares of common
stock. A share of the common stock of the company currently sells for eight times current
earnings. Management and outside analysts expect the growth rate of earnings and
dividends for the company to be 7.5 percent per year. Calculate the cost of equity capital to
this firm.
D = 1
P = 8
CRITICAL THINKING 7 8
Growth likely will be 7.5
Ke = D/P + g
Ke = 1/8 + 0.075
Ke = .2
Cost of capital for this firm is 20%
SP 15-1. The benefits and costs of an investment project (the purchase of a piece of
machinery) are those given in the following table. In Excel, calculate net revenue, or the
revenue from the investment minus the costs; the present value coefficient for every year;
and the present value of the net revenue. Add together column F to get the net present
value of the project. Should the firm purchase the machine?
End of
Year
Investme
nt (Year
0) and
Cost
Revenu
e
Net
Revenu
e
Present
Value
Coefficie
nt
Pr
es
ent
Val
ue
of
Ne
t
Re
ve
nu
e
0 1000.00
-
1000.0
0 1.00
-
10
00.
00
1 200.00 600.00 400.00 0.95
38
0.9
5
2 300.00 800.00 500.00 0.91
45
3.5
1
3 300.00 800.00 500.00 0.86
43
1.9
2
4 400.00 800.00 400.00 0.82
32
9.0
8
CRITICAL THINKING 7 9
4 200.00 200.00 0.82
16
4.5
4
Total
76
0.0
1
With the net present value of the machine being $760.01, the firm should purchase the
machine because it has a positive NPV.
Froeb
IP 17-1. You’re the manager of global opportunities for a U.S. manufacturer, who is
considering expanding sales into Europe. Your market research has identified three
potential market opportunities: England, France, and Germany. If you enter the English
market, you have a 0.5 chance of big success (selling 100,000 units at a per-unit profit of
$8), a 0.3 chance of moderate success (selling 60,000 units at a per-unit profit of $6), and a
0.2 chance of failure (selling nothing). If you enter the French market, you have a 0.4
chance of big success (selling 120,000 units at a per-unit profit of $9), a 0.4 chance of
moderate success (selling 50,000 units at a per-unit profit of $6), and a 0.2 chance of failure
(selling nothing). If you enter the German market, you have a0.2 chance of huge success
(selling 150,000 units at a per-unit profit of $10), a 0.5 chance of moderate success (selling
70,000 units at a per-unit profit of $6), and a 0.3 chance of failure (selling nothing). If you
can enter only one market, and the cost of entering the market (regardless of which market
you select) is $250,000 should you enter one of the European markets? If so, which one? If
you enter, what is your expected profit?
England
((0.5 * 100,000 * $8) + (0.3 * 60,000 * $6) + (0.4 * 0)) - $250,000 = $258,000
CRITICAL THINKING 7 10
France
((0.4 * 120,000 * $9) + (0.4 * 50,000 * $6) + (0.2 * 0)) - $250,000 = $302,000
Germany
((0.2 * 150,000 * $10) + (0.5 * 70,000 * $6) + (0.3 * 0)) - $250,000 = $260,000
France would be the best market to enter because the expected profit there would be
$302,000.
IP 17-4. Your company has a customer who is shutting down a production line, and
it is your responsibility to dispose of the extrusion machine. The company could keep it in
inventory for possible future product and estimates that the reservation value is $250,000.
Your dealings on the second-hand market lead you to believe that there is a 0.4 chance a
random buyer will pay $300,0000, a 0.1 chance the buyer will pay $400,000, and a 0.25
chance it will not sell. If you must commit to a posted price what price maximizes profits?
To maximize profits, the company should post the price at $300,000 because it yields the
highest probability to take place.
IP 19-5. Soft selling occurs when a buyer is skeptical of the usefulness of a product
and the seller offers to set a price that depends on realized value. For example, suppose
you’re trying to sell a company a new accounting system that will reduce costs by 10%.
Instead of naming a price, you offer to give them the product in exchange for 50% of their
cost savings. Describe the information asymmetry, the adverse selection problem, and why
soft selling is a successful signal.
CRITICAL THINKING 7 11
The asymmetry information in soft selling refers to the seller knowing if the product
actually works and the buyer not knowing. The buyer could be worried that the seller is lying
just to make a sale. This would be considered the adverse selection problem. The buyer will
only pay the seller if the product works. The seller knows if the product will work or not so in
this case the seller knows the product works. The seller would not receive any money if the
product does not work, so if they know that, they would not sell the product to the buyer. This is
why soft selling is successful.
IP 19-6. You need to hire some new employees to staff your start-up venture. You
know that potential employees are distributed throughout the population as follows, but
you can’t distinguish among them: What is the expected value of five employees you hire?
Expected value = $50,000
Without adverse selection, you would expect to hire an equal number of each type of
employee and your expected value would be (.25($50,000) + .25($60,000) + .25($70,000) + .
25($80,000) = $65,000
But with adverse selection, you will not realize this value. If you initially assume an
expected value of $65,000 and therefore offer that as your salary, only the $50,000 and $60,000
employees will accept. This drives your expected valued down to $55,000. If you lower your
offer to $55,000, only the $50,000 employees will accept. As the offer drops, so does the
expected value.
The only reasonable offer the company can make is $50,000.
