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Chapter 5
P5-3: Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:
Investment Expected Return Expected Risk Index
X 14% 7%
Y 12 8
Z 10 9
a. If Sharon were risk-indifferent, which investments would she select? Explain Why?
b. If she were risk-averse, which investments would she select? Why?
c. If she were risk-seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?
P5-4: Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating the possible outcomes, the company made the estimates shown in the following table:
Expansion A Expansion B
Initial Investment $12,000 $12,000
Annual Rate of Return
Pessimistic 16% 10%
Most Likely 20% 20%
Optimistic 24% 30%
a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk?
d. Assume that expansion B's most likely outcome is 21% per year and that all other facts remain the same. Does this change your answer to part c? Why?
P5-13: Portfolio analysis You have been given the return data shown in the first table
on three assets?F, G, and H?over the period 2007-2010.
Expected Return
Year Asset F Asset G Asset H
2007 16% 17% 14%
2008 17 16 15
2009 18 15 16
2010 19 14 17
Using these assets, you have isolated the three investment alternatives shown in
the following table:
Alternative Investment
1 100% of Asset F
2 50% of Asset F and 50% of Asset G
3 50% of Asset F and 50% of Asset H
a. Calculate the expected return over the 4-year period for each of the three
alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each
of the three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for
each of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives do
you recommend? Why?
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Chapter 5
P5-3: Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:
Investment Expected Return Expected Risk Index
X 14% 7%
Y 12 8
Z 10 9
a. If Sharon were risk-indifferent, which investments would she select? Explain Why?
Risk indifference implies that risk does not matter and we look for higher returns and so Sharon would select X and Y since these have a higher return than 12% currently.
b. If she were risk-averse, which investments would she select? Why?
A risk averse person would select an investment which provides the highest return per unit of risk. Sharon would select X since that offers a higher return with a small increase in risk.
c. If she were risk-seeking, which investments would she select? Why?
A risk seeking person only looks at risk without looking at return. Sharon would accept Y and Z since that have higher risk.
d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be ...
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