Deck 16: Risk Analysis

Question 1

The minimax regret criterion directs the decision maker to select the alternative that:

A) maximizes opportunity cost.
B) provides the best outcome in the worse case scenario.
C) provides the worst outcome in the best case scenario.
D) minimizes opportunity loss.

Answer 1

D

Question 2

A probability distribution for total profit is a list of:

A) possible events.
B) probabilities.
C) possible events and probabilities.
D) occurrences.

Answer 2

C

Question 3

A project with a 50% chance of earning $0 and a 50% chance of earning $100 has a standard deviation of:

A) $100
B) $50
C) $75
D) $0

Answer 3

B

Question 4

If profits are normally distributed with a mean of $12 and a standard deviation of $4, there is a 50/50 chance actual profits will exceed:

A) $12
B) $8
C) $16
D) $4

Question 5

To justify an investment that involves an out-of-pocket cost of $100 and a 50/50 chance of payoffs of $0 or $250, the decision maker must have personal certainty equivalent adjustment factor that is:

A) a = 0.8
B) a £ 0.8
C) a > 0.8
D) a < 0.8

Question 6

Economic risk is the:

A) variance of total profit.
B) standard deviation of total profit.
C) coefficient of variation for total profit.
D) chance of loss.

Question 7

For a risk seeker the marginal utility of money is:

A) constant.
B) increasing.
C) positive.
D) diminishing.

Question 8

A valuation model that explicitly accounts for risk can be written as:

A)
B)
C)
D)

Question 9

Following an increase in the risk-free rate, the certainty equivalent adjustment factor a will:

A) rise for risk adverse investors.
B) fall for risk adverse investors.
C) fall for risk seeking investors.
D) none of these.

Question 10

Risk neutrality implies a:

A) constant marginal utility of income.
B) diminishing marginal utility of income.
C) increasing marginal utility of income.
D) constant utility of income.

Question 11

If you are indifferent between $1 and a lottery ticket that gives you a 0.001 chance of winning $1,000 you are:

A) risk neutral.
B) risk averse.
C) risk elastic.
D) a risk seeker.

Question 12

A decision standard that selects the alternative with the best of the worst possible outcomes is:

A) game theory.
B) the maximin criterion.
C) the minimax criterion.
D) sensitivity analysis.

Question 13

A certainty-equivalent adjustment factor a = 0.8 is consistent with risk:

A) neutrality.
B) avoidance.
C) preference.
D) seeking.

Question 14

For two projects of differing sizes, the project that is less risky has the:

A) highest standard deviation.
B) highest coefficient of variation.
C) lowest coefficient of variation.
D) highest expected profit.

Question 15

The difficulty of selling corporate assets at favorable prices under typical market conditions is:

A) derivative risk.
B) cultural risk.
C) liquidity risk.
D) currency risk.

Question 16

The chance of loss associated with a given managerial decision is:

A) market risk.
B) inflation risk.
C) credit risk.
D) business risk.

Question 17

A project with a 75% chance of earning $4,000 in profit and a 25% chance of earning $12,000 in profit has an expected value of:

A) $8,000
B) $10,000
C) $16,000
D) $6,000

Question 18

The maximin criterion involves:

A) minimization of expected opportunity costs.
B) avoidance of the worst-case scenario.
C) acceptance of the best-case scenario.
D) maximization of expected returns.

Question 19

Economic risk is a situation where:

A) only outcome possibilities are not known.
B) only outcome probabilities are not known.
C) neither outcome possibilities nor outcome probabilities are known.
D) none of these.

Question 20

The minimum expected opportunity loss associated with a decision equals the:

A) worst outcome under the best case scenario.
B) cost of uncertainty.
C) incremental cost.
D) best outcome under the worst case scenario.

Question 21

The amount of a bet is irrational when it:

A) exceeds the maximum possible payoff.
B) is less than the maximum possible payoff.
C) exceeds the expected return.
D) is less than the expected return.

Question 22

Standard Normal. A leading company in the freight forwarding business offers Overnight Letter delivery service with a record of on-time delivery for 99% of shipped parcels. The price of this service is $15. Express Mail, offered by a leading competitor for $10, has an on-time delivery record of 95%.
A. Calculate the cost incurred due to late delivery that would make shippers indifferent to these deliver service alternatives.
B. Which delivery alternative is preferred if a $100 cost would be incurred due to late delivery?

Question 23

Probability Analysis. The Medical Centre is considering taking on a new lease for additional office space in alternative suburban shopping areas. Alternative 1 requires a current investment outlay of $50,000; alternative 2 requires an outlay of $75,000. The following cash flows will be generated each year over an initial five-year lease period.
A. Calculate the expected cash flow for each investment alternative.
B. Calculate the standard deviation and coefficient of variation of cash flows (risk) for each investment alternative.
C. The firm will use a discount rate of 15% for the cash flows with higher degree of dispersion and a 12% rate for the less risky cash flows, calculate the expected net present value for each investment. Which alternative should be chosen?

Question 24

Uncertainty is present when:

A) outcomes are unknown.
B) all possibilities are unknown.
C) all probabilities are unknown.
D) all of these.

Question 25

Certainty Equivalents. Rajun Cajun's, Ltd., is a rapidly growing chain of Cajun-style cuisine restaurants. The company has a limited amount of capital for expansion, and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Montgomery, Alabama and/or Pensacola Beach, Florida. Projections for the two potential outlets are:
Each restaurant would involve a capital expenditure of $1.5 million, and the company uses the 10% yield on risk-free U.S. Treasury bills to calculate the risk-free annual opportunity cost of investment capital.
A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution.
B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet.

Question 26

Probability Analysis. WD-50, Inc. has just completed development of a new spray lubricant. Preliminary market research indicates two feasible marketing strategies: developing general consumer acceptance through media advertising, or developing distributor acceptance through intensive personal selling by company representatives. The marketing manager has developed the following estimates for sales under each alternative:

Question 27

Risk Attitudes. Identify each of the following as consistent with risk-averse, risk-neutral, or risk-seeking behavior in investment project selection:
A. Ignoring risk levels of investment alternatives.
B. Larger risk premiums for riskier projects.
C. Valuing equally certain sums and expected risky sums of equal dollar amounts.
D. Increasing marginal utility of money.
E. Preference for larger, as opposed to smaller, coefficients of variation.

Question 28

Expected Return Analysis. Barry Bonds offers free fixed-income investment seminars to local YMCA groups. On average, Bonds expects 10% of seminar participants to purchase customized financial planning services priced at $500 each, and 25% to purchase an investment option priced at $100.
A. Calculate Bonds' expected gross return per seminar if attendance averages ten persons.

Question 29

A risk seeking decision maker displays:

A) increasing marginal utility of income.
B) increasing utility of income.
C) constant marginal utility of income.
D) decreasing marginal utility of income.

Question 30

Certainty Equivalent Method. Saddie Hawkins, a management analyst with Mobile Telephone Services, Inc., has collected the following information about three investment projects undertaken by the firm during the past six month period. Hawkins wishes to use this information as a backdrop against which to evaluate the attractiveness of a recent investment proposal put forth by the quality control department. In that proposal, dubbed Project X, the quality control department proposes to spend $100,000 to modify transmission equipment at the Colorado Springs, Colorado facility. Annual expected cost savings of $25,000 per year over the 10-year 2005-2014 period have been projected, and verified as reasonable by Hawkins.
A. Calculate the present value of anticipated cost savings using an 8% discount rate as a reasonable estimate of the risk-free cost of capital.
B. In light of the $100,000 investment required for each of these projects, and the discounted present value of future benefits, calculate the certainty equivalent adjustment factor a implicit in the decision to fund each of these investment projects.
C. Assume that the a's implicit in the decisions to fund projects Y and Z represent the upper limits for investment projects of this type. Would a decision to fund project X be consistent or inconsistent with the firm's decision to fund projects Y and Z?

Question 31

Probability Analysis. Tex-Mex, Inc. is a rapidly growing chain of Mexican-food restaurants. The company has a limited amount of capital for expansion, and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Phoenix and/or Tucson, Arizona. Projections for the two potential outlets are:
Each restaurant would involve a capital expenditure of $1.5 million, plus land acquisition costs of $500,000 for Phoenix and $1,050,000 for Tucson. The company uses the 10% yield on riskless U.S. Treasury bills to calculate the risk-free annual opportunity cost of investment capital.
A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution.
B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet.
C. Assuming the management of Tex-Mex is risk averse, and uses the certainty equivalent method in decision making, which is the more attractive outlet? Why?

Question 32

Certainty Equivalents. Rabbit Food, Inc., is a rapidly growing chain of health food restaurants. The company has a limited amount of capital for expansion, and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Fresno and/or Pasadena, California. Projections for the two potential outlets are:
Each restaurant would involve a capital expenditure of $2.5 million, plus land acquisition costs of $500,000 for Fresno and $1.5 million for Pasadena. The company uses the 10% an estimate of a minimal risk-free annual opportunity cost of investment capital.
A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution.
B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet.
C. Assuming the management of Rabbit Food is risk averse, and uses the certainty equivalent method in decision making, which is the more attractive outlet? Why?

Question 33

Expected Return Analysis. Alex P. Keaton has just accepted a job as a broker at a major NYSE member firm, and has been asked to develop a list of customers by telephoning medical doctors and other professionals located in the metropolitan area. On average, Keaton expects 1% of those called to purchase $15,000 each in mutual fund investments, and 3% to purchase $10,000 each in stocks and bonds. Keaton earns a 2% net commission on mutual funds and 1% on stocks and bonds.
A. Calculate Keaton's expected net commissions if he calls an average of twenty-five persons per day.

Question 34

Probability Analysis. Ceramic Tile, Inc. wishes to adopt one of two feasible marketing strategies: developing general consumer acceptance through media advertising, or developing distributor acceptance through intensive personal selling by company representatives. The marketing manager has developed the following estimates for sales under each alternative:

Question 35

Probability Analysis. The Seattle HMO, Inc. is considering entering into a data processing contract with a leading consulting firm. Entering into such an agreement would require a current investment outlay of $200,000. The following net cash flows (cost savings) will be generated each year over the ten-year life of the management contract:
A. Calculate the expected cash flow.
B. Calculate the standard deviation and coefficient of variation of cash flows (risk).
C. Calculate the expected net present value for the investment if the firm uses a discount rate of 20%. Should the investment be undertaken?

Question 36

Decision Trees. Atlanta Corporation has been supplying Raleigh Manufacturing, Inc. with electronic control systems, and Raleigh is satisfied with their performance. However, Raleigh has just received a competing bid from Brahmin, Inc., a firm that is aggressively marketing its products. Brahmin has offered to supply systems for a price of $237,500, or $12,500 below the $250,000 price for the Atlanta system. In addition to an attractive price, Brahmin offers a money-back guarantee. That is, if Brahmin's systems do not match Atlanta's quality, Raleigh can reject them and return them for a full refund. However, if it must reject the machines and return them to Brahmin, Raleigh will suffer a manufacturing delay costing the firm $50,000.
A. Construct a decision tree for this problem and determine the maximum probability Raleigh can assign to rejection of the Brahmin system before it would reject the offer, assuming it decides on the basis of minimizing expected costs.
B. Assume that Raleigh assigns a 40% probability of rejection of the Brahmin controls. Would Raleigh be willing to pay $5,000 for an assurance bond that would cover manufacturing delay costs if the Brahmin controls fail the quality check? (Use the same objective as in part A above.) Explain.

Question 37

When E(R) = $100,000, only a risk-seeking investor would make a certain sum investment in an amount:

A) greater than $100,000.
B) greater than or equal to $100,000.
C) of $100,000.
D) less than $100,000.

Question 38

Certainty Equivalents. Pier-4, Inc. is a rapidly growing chain of sea-food restaurants. The company has a limited amount of capital for expansion, and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Providence, Rhode Island and/or Gloucester, Massachusetts. Projections for the two potential outlets are:
Each restaurant would involve a capital expenditure of $2.5 million, and the company uses the 10% yield on risk-free U.S. Treasury bills to calculate the risk-free annual opportunity cost of investment capital.
A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution.
B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet.

Question 39

Expected Return Analysis. Dr. John Carter offers health seminars to local PTA groups. On average, Carter expects 2% of seminar participants to become patients of his HMO organization at a gross billing of $2,500 per patient per year.
A. Calculate Carter's expected net return per dollar of gross patient billings if attendance averages fifty persons per seminar, and a first-year net return of $100 must be earned to justify Carter's time and effort per seminar.

Question 40

When the dispersion of possible returns is irrelevant, the decision maker is said to be:

A) risk averse.
B) risk neutral.
C) risk seeking.
D) none of these.

Question 41

Standard Normal. Personal Business Cards, Inc. supplies customized business cards to commercial and individual customers. Although paper, ink, and other costs cannot be determined precisely, Personal anticipates that costs will be normally distributed around a mean of $15 per unit (each 500-card order) with a standard deviation of $2 per unit.
A. What is the probability that Personal would make a profit at a price of $15 per unit?
B. Calculate the unit price necessary to give Personal a 95% chance of making a profit on the order.
C. If Personal submits a successful bid of $18.20 per unit, what is the probability that it will make a profit?

Question 42

Game Theory. Catskill Mountain Bike, Inc. is a producer and wholesaler of rugged bicycles designed for mountain touring. The company is considering upgrading its current line by making standard high-grade Chromalloy frames. Of course, the market response to this upgrade in product quality would depend on the competitor response, if any. The company's comptroller projects the following annual profits (payoffs) following resolution of the upgrade decision.

A. Which decision alternative represents Catskill's secure strategy? Explain.
B. Calculate the opportunity cost (or regret) matrix.
C. Which decision alternative would Catskill choose if the company seeks to minimize opportunity cost? Explain.

Question 43

Game Theory. Jessica's, a local retailer of women's clothing is considering adoption of new Sunday hours between 12:00 PM and 6:00 PM. Jessica's is closed on Sundays. Of course, the consumer response to this extension in hours depends on the competitor response, if any. The following annual profit contributions (payoffs) are expected:

A. Which decision alternative would Jessica's choose given a secure strategy criterion? Explain.
B. Calculate the opportunity loss (or regret) matrix.
C. Which decision alternative would Jessica's choose if the company seeks to minimize opportunity cost? Explain.

Question 44

Decision Trees. Arnie Becker, an attorney with Dewey, Cheetum & Howe in Los Angeles, California, must serve a subpoena to an individual in New York, New York by 10:00 a.m. tomorrow morning. If the subpoena is delivered late, Becker stands to lose $5,000 in fees. The subpoena can be delivered by mail at a cost of $25, or by courier at a cost of $225. Based on passed experience, Becker assigns a 99% change of on-time delivery using the courier service. Because Express Mail is a relatively new service, Becker does not know the probability of on-time delivery using this service.
A. Construct a decision tree for this problem and calculate the minimum probability of on-time delivery for Express Mail that would make Becker indifferent to the two delivery services.

Question 45

Standard Normal. Chip Technologies, Inc. supplies wafer-thin computer chips to industrial customers. Although labor and material costs cannot be determined precisely, CTI anticipates that costs will be normally distributed around a mean of $3 per unit with a standard deviation of 20¢ per unit.
A. What is the probability that CTI would make a profit at a price of $3 per unit?
B. Calculate the unit price necessary to give CTI a 95% chance of making a profit on the order.
C. If CTI signs a contract to supply chips at a price of $3.20 per unit, what is the probability that it will make a profit?

Question 46

Standard Normal. University Savings, Inc offers personal checking accounts to commercial and individual customers. Although unit costs cannot be determined precisely, University anticipates that monthly costs will be normally distributed around a mean of $5 per unit with a standard deviation of $1 per unit.
A. What is the probability that University would make a profit at a checking price of $5 per unit?
B. Calculate the unit price necessary to give University a 90% chance of making a profit on an individual checking account.
C. If University offers its accounts at a price of $6, what is the probability that it will make a profit?

Question 47

Game Theory. F&M Manufacturing, Inc., a diversified manufacturer of packaging products, is considering upgrading its current line by making available a new line of coated paper products. Of course, the market response to this upgrade in product quality would depend on the competitor response, if any. The company's comptroller projects the following annual profits (payoffs) following resolution of the upgrade decision.
A. Which decision alternative would F&M choose given a secure strategy criterion? Explain.
B. Calculate the opportunity loss or regret matrix.
C. Which decision alternative would F&M choose if the company seeks to minimize opportunity cost? Explain.