QCT_7_answers.pdf.pdf

BUSI 620

Answers for QCT 7

Salvatore’s chapter 14:

a.Discussion Questions:

12. The rationale behind the minimax regret decision rule is to minimize the maximum

regret or opportunity cost of making the wrong decision under each state of nature, after a

particular state of nature has actually occurred. 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

environment in which the firm operates by patents, copyrights, and exclusive franchises;

(4) hedging (i.e., entering into a contract to buy or sell a specific quantity of a

commodity, security, foreign currency, etc., for delivery at a future date, at a price agreed

upon today); and (5) diversification into various product lines by a firm, different

securities in a portfolio, and various lines of business by a conglomerate corporation.

The minimax regret rule is useful when the decision maker wants to minimize the

maximum regret or the opportunity cost of a decision under whatever state of nature

occurs. The other more informal and less precise methods of dealing with uncertainty are

useful under particular circumstances, and are often employed by experienced business

executives. Which of the more formal decision rules or more informal methods of dealing

quality borrowers, until interest rates would have to be so high that it would not pay even

for low-quality borrowers to borrow.

Credit-card companies reduce the adverse selection problem that they face by sharing the

credit histories of borrowers with other credit-card companies. The sharing of borrowers'

credit histories by credit-card companies in order to reduce the adverse selection problem

that they face gives rise to complaints of invasion of privacy. This is true, but without

sharing credit histories, credit-card companies would have to charge much higher credit

rates, which might be unacceptable to most borrowers.

b.Problems:

Spreadsheet problems

(b) Investment A is less risky than investment B because its standard deviation is smaller,

but it also provides a lower expected income.

(c) It is not clear, therefore, from the information given which investment is best. It

depends on whether the lower expected income from investment A is more than balanced

by its lower risk. This depends on the attitude of the individual toward risk.

2.

(a) From the spreadsheet, the expected value of project A of 2.8 is higher than 2.7 for

project B, so it is preferred.

(b) Project B has a higher expected utility of 2.315, however, so it is preferred under this

criterion.

Payment Probability

$25,0001 – (0.6+0.25+.12) = 0.03

$5,000 0.12

$0 0.25

$0 0.6

Expected payment = 0.03*25,000 + 0.12*5,000 + 0.25*0 + 0.6*0 = $1,350

Expected payment + $200 profit = $1,550

17-4

Hotdog Uncertainty

Compute expected payoffs:

“Soft Selling” and Adverse Selection

The seller of the product knows whether the product works; the buyer does not (the

asymmetric information). The buyer is worried that the seller has an incentive to lie—to

tell him that the product will reduce costs regardless of whether they will (the adverse

selection). The buyer “signals” the quality of his product by offering to be paid only if it

works. A seller who knew his product didn’t work would not offer this kind of contract.

19-5

Hiring Employees

Expected value = $50,000

Without adverse selection, you would expect to hire an equal number of each type of

The only reasonable offer you can make is $50,000.

Salvatore’s chapter 15:

a.Discussion Questions:

7.

(a) Only when evaluating mutually exclusive investment projects can the NPV and the

IRR methods provide contradictory signals as to which investment project the firm should

undertake. For a single or independent project the two methods will always give the same

accept/reject investment signal.

(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

from the project at the same higher IRR earned on the project.

b.Problems:

8.

(a) The NPV of each project is obtained by subtracting from the present value of the net

cash flows (PVNCF) for each project the initial cost of the investment (C0).

Thus, NPV = $600,000 for project A, $450,000 for project B, and $300,000 for project C.

With capital rationing, the firm can undertake either project A only or projects B and C.

Ranking projects according to their NPV, the firm would undertake projects B and C with

total NPV of $750,000

(b) Since the firm faces capital rationing, however, it should use the profitability index (PI)

and C. The reason for this is that projects B and C provide a higher rate of return

per dollar invested than project A. Note that the sum of the NPV of projects B and C

exceeds the NPV for project A.

10. The cost of equity capital for this firm (ke) can be calculated with the dividend valuation

model, as follows

ke = (D/P) + g

where D is the amount of the yearly dividend paid per share of the common stock of the

firm, P is the price of a share of the common stock of the firm, and g is the expected annual

growth rate of dividend payments.

Since the company pays half of its expected $200 million in net after-tax earnings in

Spreadsheet problem 1: The present value of net revenue is $760. The firm should