Exam 14: Risk in Project Analysis

In project analysis, the assumption usually made is that the decision maker is a risk seeker.

The probability distribution that would be represented by a line rather than a bar graph and would contain information on the probability values associated with a wide range of possible payoffs would be called:

An elementary event consists of a number of composite events.

A investor that is given a choice between two investments with the same expected return and who always prefers the less risky one is said to be:

Use the following information to answer questions 10-12 A one year project has the following possible returns in relation to the percentage growth in personal income: The management of Roller King has determined the following subjective probabilities concerning the percentage growth in personal income: -What is the Expected value of the cash inflow from the project?

A risk-averse investor is one that given a choice between two investments with the same expected return would always prefer the less risky one.

A subjective probability is a probability value that is assigned to an event by an investigator.

Each event in a listing of all the possible outcomes of a given situation is called:

Develop a set of certainty equivalent adjustment factors to 4 decimal places) from the following information. The data has been derived from the decision maker's preferences.

A risk-neutral investor will choose the riskier of two investments with the same expected return, regardless of their risk.

Use the following information to answer questions 13 - 15 The following data is on two one period capital projects. -What is the standard deviation of probable cash flows from each project?

The expected value of an investment is found by multiplying each possible outcome by the probability that it will occur, then summing these values.

An event's probability can be viewed as the odds that the event will occur or the percentage of times it will take place when a given set of circumstances is repeated many times.

A investor that is given a choice between two investments with the same expected return and who always prefers the riskier one is said to be:

Develop a set of certainty equivalent adjustment factors to 4 decimal places) from the following information. The data has been derived by the firm's management.

Genovese, Capone and Lansky, Inc., a small importer of virgin olive oil in the Chicago area, has two possible investment opportunities. The first is to expand in an area already being developed by the company. The expansion bribes to local officials, cement, bullets, legal and accounting fees, bribes to state officials, dead fish, old newspaper, white ties, spaghetti sauce, bribes to federal officials, wine, bullet proof cars, etc.) is expected to cost $498,000,000. As expenses of this size require two signatures, Ralphie "The Terminator" Franconi has called in his administrative assistant Vinnie "The Calculator" Melillo. Mr Melillo, a recent graduate of the Harvard Business School, also called in his father, Gennaro "The Slide Rule" Melillo, for some additional advice. After considerable time and effort, and the help of their "Big 6" outside auditors, they were able to arrive at a cash flow estimate. The accountants were a little confused as to how all that money was going to come from an operation that imported only 12 cases of olive oil in all of 1996. They were told to make believe it was 1985 and they were auditing an S & L - close their eyes, collect their fees and keep their mouths shut. They determined that the net cash inflows are expected to be $211,900,000 per year over the life of the project, which is 6 years. The other opportunity is to develop a relatively little known area of South Texas, the city of San Antonio. They believe growth resulting from NAFTA will create many opportunities in San Antonio. Due largely to the lower cost of bribing local officials, the project will cost only $315,000,000 and have net cash inflows of $152,540,000 per year for 6 years. Even with the political unrest in Chicago, Genovese, Capone and Lansky, Inc. realizes that it will be more risky to develop the property in South Texas due to the greater political instability of the area. The firm's executive committee, chaired by Guido "Boom Boom" Mezanotti, has assigned a risk adjusted discount rate of 32% to the South Texas project and 28% to the Chicago project since it believes that the Chicago project is less risky). However, due to the level of political unrest in both of the areas, and the growing movement toward term limitations in Chicago and the adoption of term limitations in San Antonio, management is unwilling to assign salvage values to either of the projects. Which project should Genovese's management accept if it can accomplish only one project out of this month's cash flows?

A continuous probability distribution would:

The variance, a measure of the dispersion of possible project outcomes, is one indicator of risk.

If we assume that the decision maker is risk-averse, then we can conclude that the economic nature of risk is that its presence lessens the desirability of a given undertaking or investment project.

A project, or combination of investments, that will involve the least risk for a given rate of return is: