Economics Of Risk And Uncertainty Applied Problem Case Study Samples
Present value for second alternative = 70000001+0.08+70000001+0.082≈$ 12.48 million
Since the present value for the second alternative is larger than $ 12 million in the first alternative, the second alternative is better for the students.
Present value for second alternative = 70000001+0.12+70000001+0.122≈$ 11.83 million
Since the present value for the second alternative is less than $ 12 million in the first alternative, the first alternative is better for the students.
An example would be a company in a decision to buy a property. The property agent may give the company two choices. The first one is where the company pays the full amount in one lump sum today when the company agrees to buy. The second choice is where the company pays a larger amount at the end of a number of years which is equal to the same amount paid in the first choice plus some interest. The interest would not be zero, because if the company pays the agent in one lump sum, the property agent would have the chance to invest the payment in the bank, for example. But in the second choice, the property agent has less capital for investment. So, the agent needs to charge the company some interest.
The expected net present value, ENPV is the present value of the cash inflow minus the initial investment. The standard deviation is a measure of the deviation one can get from the possible outcome of the investment and its future cash inflow.
For Year 1, cash flow = 0.250+0.340+0.430+0.120=$36 million
For Year 2, cash flow = 0.160+0.250+0.340+0.430=$40 million
For Year 3, cash flow = 0.370+0.460+0.150+0.240=$58 million
Expected net present value, ENPV = -80+361+0.08+401+0.082+581+0.083≈$33.67 million
For Year 1,
For Year 1, standard deviation = 85
For Year 2,
For Year 2, standard deviation = 125
For Year 3,
For Year 3, standard deviation = 125
Standard deviation corresponding to the ENPV = 851.082+1251.084+1251.086=$15.605 million
Since the ENPV is positive, San Diego LLC should decide to accept this project.
Since the ENPV for project B, i.e. $32 million is less than the ENPV for Project A, the company should still choose Project A.
The coefficient of variation is the ratio of the standard deviation to the ENPV.
Coefficient of variation for Project A = 33.6715.605≈2.16
Coefficient of variation for Project B = 3210.5≈3.05
As the CEO, I would choose Project A, as it has a smaller coefficient of variation than Project B. A smaller coefficient means the risk per dollar of return is smaller. The risk is measured by the standard deviation, which is in statistical terms, how much deviation is the expected outcome from the ENPV can one get.
Douglas, E. J. (2012). Managerial Economics. San Diego, CA: Bridgepoint Education, Inc.
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