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P8–3 Risk preferences Sharon Smith, the financial manager for
Barnett Corporation, wishes to evaluate three prospective
investments: X, Y, and Z. Sharon will evaluate each of these
investments to decide whether they are superior to investments that
her company already has in place, which have an expected return of
12% and a standard deviation of 6%. The expected returns and
standard deviations of the investments are as follows:
a. If Sharon were risk neutral, 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?
Investment Expected return Standard deviation
X 14% 7%
Y 12 8
Z 10 9
P8–4 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.
Expan sion A Expansion B
Initial investment $12,000 $12,000
Annual rate of return
Pessimistic 16% 10%