Running head: QUESTIONS FOR CRITICAL THINKING 7 1
Questions for Critical Thinking 7
Liberty University
QUESTIONS FOR CRITICAL THINKING 7 2
Questions for Critical Thinking 7
Salvatore Chapter 14:
a. Discussion Questions 12
What is the rationale behind the minimax regret rule? What are some of the less
formal and precise methods of dealing with uncertainty? When are these useful?
The rationale behind the minimax regret rule is to minimize the maximum regret or
opportunity cost of wrong decision, regardless of the state of nature that actually occurs
(Salvatore, 2015, Pg.619). The regret of each decision is measured by the difference
between the strategy’s payoff and the best strategy’s 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 less formal methods are as follows:
Understanding and acquiring additional information
Contacting government agencies to remove uncertainty on decision making
Changing the company's holdings to a more diverse portfolio
Discussion Question 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 referred to a situation when a 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 (Salvatore, 2015, Pg.627). Thus, credit card companies are
more likely to attract borrowers who either do not repay their debts or repay them late,
which creates an adverse selection problem and increases interest rates. When doing so,
credit card companies hedge themselves from borrowers that may default. Nonetheless,
QUESTIONS FOR CRITICAL THINKING 7 3
high interest rates can create a weakened economy, so in order to keep a balance, credit
card companies should be careful not to increase rates too significantly.
b. Spreadsheet problems 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.
Investment A Investment B
Income Probability Income Probability
$4,000 0.2 $4,000 0.3
$5,000 0.3 $6,000 0.4
$6,000 0.3 $8,000 0.3
$7,000 0.2
a) Usin
g Excel’s
statistical
tools,
calculate the
standard
deviation of
the
distribution
of each
investment.I
nvestment A
b) c) d) e) f)
g) Inco
me
h) Pr
obability
i) E
xpected
Income
j) D
eviation
k) D
eviation
Squared
l) Deviation
Squared*Probability
m) 4000 n) 0.2 o) 8
00
p) -
1500
q) 22
50000
r) 450000
s) 5000 t) 0.3 u) 1
500
v) -
500
w) 25
0000
x) 75000
y) 6000 z) 0.3 aa) 1
800
ab) 5
00
ac) 25
0000
ad) 75000
ae) 7000 af) 0.2 ag) 1
400
ah) 1
500
ai) 22
50000
aj) 450000
ak) al) am) 5
500
an) ao) Va
riance
ap) 1050000
aq) ar) as) at) au) St
andard
av) 1024.695077
QUESTIONS FOR CRITICAL THINKING 7 4
Deviation
aw)
Investment B
Income Probability Expected
Income
Deviation Deviation
Squared
Deviation
Squared*Probability
4000 0.3 1200 -2000 4000000 1200000
6000 0.4 2400 0 0 0
8000 0.3 2400 2000 4000000 1200000
6000 Variance 24000000
Standard
Deviation
1549.193338
The standard deviation of investment A is 1024.7 and standard deviation of
investment B is 1549.2.
ax) Which of the two investments is more risky?
Investment A is less risky because the standard deviation is smaller (1024.7 in
comparison to 1549.2), but it also provides a lower expected income of 5,500
versus 6,000.
ay) Which investment should the individual choose?
The individual should choose investment B, because it yield the greatest return.
Spreadsheet problem 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
probably distribution of the conditions is as follows:
Conditions: Poor Good Excellent
Probability 40% 50% 10%
QUESTIONS FOR CRITICAL THINKING 7 5
aUsing
Excel,
calculate the
expected
value of each
project and
identify the
preferred
project
according to
this
criterion.Proje
ct A
bc d e f
g State of
Nature
h Pr
obability
i P
rofit
j E
xpected
Profit
k As
sociated
utility
l E
xpected
utility
m Poor n 0.4 o0p0q0r0
s Good t 0.5 u4v2w3.
2
x1
.6
y Excellen
t
z0.1 aa 8ab 0
.8
ac 4.
8
ad 0
.48
ae Total af ag ah 2
.8
ai aj 2
.08
ak
Project B
State of Nature Probability Profit Expected
Profit
Associated
utility
Expected
utility
Poor 0.4 2 0.8 1.8 0.72
Good 0.5 3 1.5 2.55 1.275
Excellent 0.1 4 0.4 3.2 0.32
Total 2.7 2.315
Using the expected value criterion, Project A is the preferred project because it has an
expected profit of 2.8, which is greater than the 2.7 expected profit from Project B.
al Assume that the individual’s utility function for profit is U(X) =X-0.05X2. Calculate
the expected utility of each project and identify the preferred project according to
this criterion.
QUESTIONS FOR CRITICAL THINKING 7 6
Using the utility function criterion, Project B is the preferred project because the utility
expect is 2.315 compared to only 2.08 of Project A.
am Is this individual risk adverse, risk neutral, or risk seeking? Why?
The individual is risk adverse because the utility function of profits increases at a
decreasing rate, so that the marginal utility of profit diminishes.
Froeb et al. Chapter 17:
Individual problem 17–1
You’re the manager of global opportunities for a US manufacture, 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 a 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 German market, you have a 0.2 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?
After subtracting the $250,000 entry cost, the expected profit for each market equals:
England: $258,000
France: $302,000
Germany: $260,000
Thus, based on the new results, France has the highest expected profit.
QUESTIONS FOR CRITICAL THINKING 7 7
Individual Problem 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 of $250,000. Your
dealings on the second-hand market lead you to believe that these is a 0.4 chance a random
buyer will pay $300,000 a 0.25 chance the buyer will pay $350,000, 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 prices maximizes profit?
In this scenario, the machine is worth 250,000, so in order to maximize profits the machine
would have to be sold at a higher amount. Based on the different buying prices, ($300,000 x 0.4)
+ ($350,000 x .25) + ($400,000 x 1) + ($0 x .25) = $120,000 + 87,500 + 40,000 + 0 = $247,500.
If you must commit to a posted price, $400,000 would maximize profit, but there’s only a 10%
chance it would sell. Thus, based on the expected profits, the best option would be to sell it for
$300,000.
Froeb et al. Chapter 19:
Individual problem 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
that 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.
QUESTIONS FOR CRITICAL THINKING 7 8
Information asymmetry is an economic theory that deals with the study of decisions in
correlation with where one party has more or better information than the other party. The unequal
distribution of information creates an imbalance of power during transactions. An example of
this is adverse selection, which is when the less knowledgeable group agrees upon a contract or
decision to purchase a product from a knowledgeable group. When this happens, the less
knowledgeable group lacks the ability to completely understand the information regarding
transaction, and therefore also loses the ability to retaliate.
In the given scenario, soft selling helps the company selling the new accounting system, because
it alleviates the buyer’s skepticism of the system. By allowing the buyer to use the system free of
cost in exchange for 50% of the cost savings, the seller is able to effectively make a profit from
the system sold. However, when the buyer and seller make this transaction, the buyer is unaware
that this system will reduce costs by 10%.
Depending on the size of the company, 10% could be a large amount of money, and it might have
been cheaper for the buyer to purchase the system rather than provide the buyer with 50% of the
cost savings. If this is the case, adverse selection could cause problems between the buyer and
seller in the future once the buyer realizes the seller is receiving more money than expected.
Individual problem 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:
Employee Value Probability
$50,000 0.25
$60,000 0.25
$70,000 0.25
$80,000 0.25
QUESTIONS FOR CRITICAL THINKING 7 9
What is the expected value of five employees you hire?
Since you are sampling from the entire population, the expected value of any one employee is
the same.
Thus, the expected value of one employee = 50,000*0.25 + 60,000*0.25 + 70,000*0.25 +
80,000*0.25 = $65,000.
Based on the expected value, you would not offer a salary of more than $65,000. In the given
scenario, the two highest value employees would not accept your offer. This then changes the
probability so that there is a 50% chance of each of the two lowest valued employees.
Thus the expected value would change to = 50,000*0.5 + 60,000*0.5 = $55,000.
But for a $55,000 offer, only the employee with the lowest value would take the job.
Therefore, if you hire 5 employees, the expected value of these 5 employees = 5*$50,000 =
$250,000.
Salvatore Chapter 15:
a. Discussion Question 7
a) When can the NPV and the IRR methods of evaluating investment projects
provide contradictory results?
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. Thus, creating mixed signals as to which
project will create more value to the firm (Salvatore, 2015, Pg.650).
b) How can this arise?
The NPV and IRR methods can provide contradictory mixed signals because
under the NPV, the net cash flows generated by the investment project are
implicitly reinvested at the firm’s cost of capital or risk-adjusted discount rate.
While under the IRR method, the net cash flows generated by the project are
QUESTIONS FOR CRITICAL THINKING 7 10
implicitly reinvested at the same higher IRR earned on the given project
(Salvatore, 2015, Pg.651).
c) Which method should then be used? Why?
The NPV method should be used because there is no certainty that the firm can
reinvest in the net cash flow at the same higher IRR earned on the project. Thus,
is it better to use the NPV when the two methods provide contradictory signals
(Salvatore, 2015, Pg.651).
b. Problem 8
John Piderit, the general management of the Western Tool Company, is considering
introducing some new tools to the company’s product line. The top management of
the firm has 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 the coming year.
Project A Project B Project C
Present Value of net cash flow
(PVNCF)
$3,000,00
0
$1,750,000 $1,400,000
Initial cost of project (C0) 2,400,000 1,300,000 1,100,000
a) Which project(s) would the firm undertake if it used the NPV investment
criterion?
NPV of Project A = $3,000,000 – $2,400,000 = $600,000
NPV of Project B = $1,750,000 – $1,300,000 = $450,000
NPV of Project C = $1,400,000 - $1,100,000 = $300,000
The best option(s) that the firm can undertake are projects B and C because the
NPV for both is of $750,000, compared to $600,000 for project A alone.
b) Is this the correct decision? Why?
Thought the use of the profitability index, undertaking projects B and C is proven
to provide a higher rate of return per dollar invested.
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
QUESTIONS FOR CRITICAL THINKING 7 11
Problem 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 common stock of the company current 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
Growth will be 7.5
Ke = D/P + g
Ke = 1/8 + 0.075
Ke = 0.2
Therefore, cost of equity capital to this firm is 20%
Spreadsheet problem 1
The
benefits
and costs
of an
investme
nt project
(the
purchase
of a piece
of
machiner
y) are
those
given in
the
following
table. In
excel,
calculate
the net
revenue,
or the
revenue
Investment
(Year 0) and
Cost
Revenue Net
Revenue
Present Value
Coefficient
Present
Value of
Net
Revenue
QUESTIONS FOR CRITICAL THINKING 7 12
from the
investme
nt minus
the costs;
the
present
value
coefficien
t 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
0 1000.00 -1000.00 1.00 -1000.00
1 200.00 600.00 400.00 0.95 380.95
2 300.00 800.00 500.00 0.91 453.51
3 300.00 800.00 500.00 0.86 431.92
4 400.00 800.00 400.00 0.82 329.08
4 200.00 200.00 0.82 164.54
Total Present
Value
760.01
The net present value of the machine is $760.01. Therefore, since the NPV is positive, the
firm should purchase the machine.
QUESTIONS FOR CRITICAL THINKING 7 13
References
Froeb, L. M., McCann, B. T., Ward, M. R., & Shor, M. (2016). Managerial economics: A problem
solving approach (4th ed.). Boston, MA: Cengage Learning. ISBN: 9781305259331.
Salvatore, D. (2015). Managerial economics in a global economy (8th ed.). New York, NY:
Oxford University Press. ISBN: 9780199397129.
