(*) Consider a firm that is run by a manager who acts in the interest of...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
(*) Consider a firm that is run by a manager who acts in the interest of the existing risk neutral shareholders. At date t = 1, the firm has liquid assets (or cash) W and can choose between two types of projects. There is a safe project that yields a return (1+r). As there is no discounting and capital markets are competitive, the risk-free return rate r equals 0. Thus, investing W in the safe project at date t = 1 results in a return W at date t = 2. Alternatively, the firm can invest in a risky project. This projects requires an investment outlay F at date t = 1 and generates at date t = 2 a random verifiable cash flow XE {XL, XH} with X > F> XL> 0 and = Pr[X = X"] and hence (1-0) - Pr[X = X]. For simplicity, we assume that the firm's current liquid assets are exactly sufficient to fund the risky project, i.e., W = F. The success probability is a random variable that is uniformly distributed over the interval [0, 1]. Hence, the NPV of the risky project depends on the realization of which is unknown to the shareholders and all other (potential) investors. By contrast, the manager observes the realization of before making the investment decision. (a) Derive the condition in terms of 0 for which the firm invests in the risky (safe) project. Does the manager take the efficient (first best) investment decision (risk choice)? (b) Given the firm's investment policy, i.e., the manager's choice be- tween the safe and the risky project, what is the ex ante expected net return, i.e., prior to the realization of 0. Reminder: The mean of a random variable uniformly distributed on the support [a, b] is E[2] = (a + b)/2. Accordingly, the mean of 2 conditional on 2 c where a K> X. Explain why the investment policy does or does not differ relative to the investment policy chosen in part a). Remark: This part of the question can be solved independently of part b). (*) Consider a firm that is run by a manager who acts in the interest of the existing risk neutral shareholders. At date t = 1, the firm has liquid assets (or cash) W and can choose between two types of projects. There is a safe project that yields a return (1+r). As there is no discounting and capital markets are competitive, the risk-free return rate r equals 0. Thus, investing W in the safe project at date t = 1 results in a return W at date t = 2. Alternatively, the firm can invest in a risky project. This projects requires an investment outlay F at date t = 1 and generates at date t = 2 a random verifiable cash flow XE {XL, XH} with X > F> XL> 0 and = Pr[X = X"] and hence (1-0) - Pr[X = X]. For simplicity, we assume that the firm's current liquid assets are exactly sufficient to fund the risky project, i.e., W = F. The success probability is a random variable that is uniformly distributed over the interval [0, 1]. Hence, the NPV of the risky project depends on the realization of which is unknown to the shareholders and all other (potential) investors. By contrast, the manager observes the realization of before making the investment decision. (a) Derive the condition in terms of 0 for which the firm invests in the risky (safe) project. Does the manager take the efficient (first best) investment decision (risk choice)? (b) Given the firm's investment policy, i.e., the manager's choice be- tween the safe and the risky project, what is the ex ante expected net return, i.e., prior to the realization of 0. Reminder: The mean of a random variable uniformly distributed on the support [a, b] is E[2] = (a + b)/2. Accordingly, the mean of 2 conditional on 2 c where a K> X. Explain why the investment policy does or does not differ relative to the investment policy chosen in part a). Remark: This part of the question can be solved independently of part b).
Expert Answer:
Answer rating: 100% (QA)
a To determine the condition for the firm to invest in the risky project we compare the net present value NPV of the ... View the full answer
Related Book For
Managerial Economics Foundations of Business Analysis and Strategy
ISBN: 978-0078021718
11th edition
Authors: Christopher Thomas, S. Charles Maurice
Posted Date:
Students also viewed these accounting questions
-
Consider a firm that is deciding whether to operate plants only in the United States or also in either Mexico or Canada or both. Congress is currently discussing an overseas investment in new capital...
-
Consider a firm that has given stock options on 20,000 shares to its senior executives. These call options can be exercised at a price of $22 anytime during the next three years. The firm has a total...
-
A firm that is marketing multimillion-dollar wastewater treatment systems to cities has been unable to sell a new type of system. This setback has occurred even though the firms systems are cheaper...
-
A quality of information demonstrated when different independent observers could reach the same general conclusions that the information represents what it purports to represent is: O a...
-
Your parents have just retired and have asked you for some financial advice. They have decided to invest $100,000 in a company very similar to Kroger. The company has issued both common and preferred...
-
When several conditions are necessary for the top event to occur, we use the "AND" symbol. If the failure rates (IE probabilities) are known for each of these conditions, we would then do the...
-
Ernst & Young, LLP is the independent public accountant for AMR Corporation, the parent company of American Airlines and American Eagle. In February 2013 AMR and US Airways Group announced the two...
-
A global manufacturer of electrical switching equipment (ESE) is considering outsourcing the manufacturing of an electrical breaker used in the manufacturing of switch boards. The company estimates...
-
Real cashflows must be discounted to get the present value at a rate equal to A B C D DDD the money discount rate the inflation rate the real discount rate the risk free rate of interest
-
Haverhill Engineers Ltd manufactures components for the car industry. It is considering automating its line for producing crankshaft bearings. The automated equipment will cost 700,000. It will...
-
+ 1. PNG electric company manufactures a number of electric products. Rechargeable light is one of the PNG's products that sells for $180/unit. Total fixed expenses related to rechargeable electric...
-
Suppose Irwin's finds a supplier for this particular fan model who is able to deliver to Irwin in 2 days and customer are willing to wait that long. The supplier charges a premium of 10 per fan for...
-
On June 30, 2024, Exploration Incorporated signs a lease requiring quarterly payments each year for the next five years. Each of the 20 quarterly payments is $28,969.97, with the first lease payment...
-
A sum of $4000 is due for payment three years from now. If the money is worth 9% p.a., compounded semi-annually, determine the equivalent value now.
-
what is a tactical process map and how does it relate to a Value Stream Map?
-
How is the Indian corporate sector being affected by the current trend of issues related to training and development?
-
What command decisions will an incident commander have to make regarding on scene resource allocation? Please provide an example from an emergency response from your organization that supports your...
-
A glass manufacturer produces hand mirrors. Each mirror is supposed to meet company standards for such things as glass thickness, ability to reflect, size of handle, quality of glass, color of...
-
Using optimization theory, analyze the following quotations: a. The optimal number of traffic deaths in the United States is zero. b. Any pollution is too much pollution. c. We cannot pull U.S....
-
In his analysis of Californias Proposition 103 (see Illustration 4.2), Benjamin Zycher notes that one of the most important provisions of this proposition is eliminating the practice by insurance...
-
For the short-run production function in exercise 1, let the wage be $20. a. Derive AVC (Q). b. When 160 units are produced, _______ units of labor are employed, and the average product is...
-
Define a forward stock split. What is the major reason for a forward stock split?
-
What information is presented in a statement of retained earnings? What information is presented in a statement of stockholders' equity?
-
How is a corporation's dividend yield calculated?
Study smarter with the SolutionInn App