5. You have received your MBA from Trinity University and been hired by a Fortune 500 company as the Executive Vice President of Finance. You are faced with three investment alternatives with the following payoffs (thousands of dollars).
Decision Alternative Up(s1) Stable(s2) Down(s3)
Investment A(d1) 100 25 0
Investment B(d2) 75 50 25
Investment C(d3) 50 50 50
Probabilities 0.40 0.30 0.30
a. Using the expected value approach, which decision is preferred?
b. For the lottery having a payoff of $100,000 with probability p and $0 with probability (1-p), two decision makers expressed the following indifference probabilities. Find the most preferred decision for each decision maker using the expected utility approach.
Indifference Probability (p)
Profit Decision Maker A Decision Maker B
$75,000 0.80 0.60
$50,000 0.60 0.30
$25,000 0.30 0.15
Expected Value = Summation of (Probability of event i * Payoffs under Event i)
Expected value of Investment A(d1) = 0.4*100+0.3*25+0.3*0= 47.50
Expected value of Investment B(d2) =0.4*75+0.30*50+0.30*25 =52.50
Expected value of Investment C(d3) =0.4*50+0.30*50+0.30*50= 50.00
Since Expected value is highest for Investment B (d2), the Investment B is preferred.
Note above figures are in thousands.
b. For the lottery having a payoff of $100,000 with probability p and $0 with ...
This solution explains how to use the expected value approach.