Running head: WEEK 1 ASSIGNMENT 1

Week 1 Assignment - Economics of Risk and Uncertainty Applied Problems

Marcell Walker

BUS640
WEEK 1 ASSIGNMENT 2

Economics of Risk and Uncertainty Applied Problems

PROBLEM 1

PART A
Amount Period Rate Discount Factor Discounted CF
7000000 Year 1 8% 0.926 6482000
7000000 Year 2 8% 0.857 5999000
12481000

PART B
Amount Period Rate Discount Factor Discounted CF
7000000 Year 1 12% 0.893 6251000
7000000 Year 2 12% 0.797 5579000
11830000

PART C
Financial Managers use Present Value (NPV/FPV) calculations to manage and account for the
time value of money (NPV). One scenario is providing service is one year and receiving
payments in later year. As such, we assume the company provides a service in December 2011
and agrees to be paid $100 in December 2012.

The time value of money tells us that the part of the $100 is interest, which is for waiting one
year for the $100. Perhaps only $91 of the $100 is service revenue earned in 2011 and $9 is
interest earned in 2012. The calculation of present value will remove the interest, so that the
amount of the service revenue can be determined. Another example might involve the purchase
of land: the owners will either sell it to for $160,000 if he receives the money today, or for
$200,000 if paid at the end of two years. At the end of two years, he would have earned interest
for two years on the amount had he received it today
WEEK 1 ASSIGNMENT 3

PROBLEM 2

Describe and calculate Project A’s expected net present value (ENPV) and standard
deviation (SD), assuming the discount rate (or risk-free interest rate) to be 8%. What is the
decision rule in terms of ENPV? What will be San Diego LLC’s decision regarding this
project? Describe your answer.

The cash for year one cash flow

𝐶𝐹 𝑌𝑒𝑎𝑟 1 = 0.2 ∗ 50 + 0.3 ∗ 40 + 0.4 ∗ 30 + 0.1 ∗ 20 = $36 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

The cash for year two cash flow

𝐶𝐹 𝑌𝑒𝑎𝑟 2 = 0.1 ∗ 60 + 0.2 ∗ 50 + 0.3 ∗ 40 + 0.4 ∗ 30 = $40 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

The cash for year three cash flow

𝐶𝐹 𝑌𝑒𝑎𝑟 3 = 0.3 ∗ 70 + 0.4 ∗ 60 + 0.1 ∗ 50 + 0.2 ∗ 40 = $58 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

Amount Period Rate Discount Factor Discounted CF

36,000,000 Year 1 8% 0.926 33336000
40,000,000 Year 2 8% 0.857 34280000
58,000,000 Year 3 8% 0.794 46052000
134,000,000 ENPV 113668000

Initial Investment 80,000,000

ENPV 113668000
Net Present Value 33,668,000

Standard Deviation

Year 1 Variance
Expected Value
10,000,000 39,200,000,000,000
12,000,000 480,000,000,000,000
12,000,000 360,000,000,000,000
2,000,000 40,000,000,000,000
Variance 919,200,000,000,000
SD $ 30,318,311.30
WEEK 1 ASSIGNMENT 4

Year 2
Expected Value
6,000,000 40,000,000,000,000
10,000,000 500,000,000,000,000
12,000,000 480,000,000,000,000
12,000,000 360,000,000,000,000
Variance 1,380,000,000,000,000
SD $ 37,148,351.24

Year 3
Expected Value
21,000,000 43,200,000,000,000
24,000,000 1,440,000,000,000,000
5,000,000 250,000,000,000,000
8,000,000 320,000,000,000,000
Variance 2,053,200,000,000,000
SD $ 45,312,250.00

Based on ENPV, San Diego should accept the new venture as it will be in their best interest
because ENPV generated through project is positive. When a form generate positive ENPV, it
means that the new project or investment has the ability to generate cash flows that are sufficient
enough to recover the initial amount generate profits considering the time value of money factor.

The company is also considering another three-year project, Project B, which has an ENPV
of $32 million and standard deviation of $10.5 million. Project A and B are mutually
exclusive. Which of the two projects would you prefer if you do not consider the risk
factor? Explain.

If ignore the risk factor, I would like to choose Project A because it has higher ENPV as
compared to project B. However, I am risk aversion attitude, then I would opt for Project B
because it has lower standard deviation which means riskiness in project B is lower however,
ENPV is also lower. Therefore, choosing project will be based investor’s attitude towards risk.

Describe the coefficient of variation (CV) and the standard deviation (SD) in connection
with risk attitudes and decision making. If you now also consider your risk-aversion
attitude, as the CEO of the San Diego LLC will you make a different decision between
Project A and Project B? Why or why not?
WEEK 1 ASSIGNMENT 5

The CV is normalized measure of dispersion of a probability distribution or frequency

distribution. It is also regarded as variation coefficient and unitized risk. Whereas on the other
hand SD is risk in an investment which is linked with fluctuations in mentioned cash flow
stream. Therefore, higher CV and SD the more will be the riskier investment. Based on this
discussion, if I have risk aversion attitude, I would choose project B because of lower standard
deviation.