It is the end of your final year of study as a student in the Master of Finance program and you are trying to determine what you are going to do over the remaining 35 years of your working life. You are trying to decide whether you should remain at university and do your PhD in finance or alternatively leave university and become a consultant.

You anticipate that it will take you 5 years to complete your PhD during which time you will earn a real net cash flow of $25,000 p.a. At the end of these 5 years you must decide whether to remain at the university as an academic or take up a career as a consultant. There is a 10% chance that you will enjoy great success as an academic earning a salary of $85,000 p.a., a 50% chance that you will have a moderately successful career earning a salary of $65,000 p.a. and a 40% chance that you will have an unsuccessful academic career earning a salary of only $45,000 p.a. If you decide to become a consultant then it will initially cost you $100,000 to set up your business and there is an 80% chance of generating $60,000 p.a. and a 20% chance of generating $120,000 p.a..

If you decide not do a PhD and instead become a consultant immediately, there is a 60% chance that you will earn $70,000 p.a. and a 40% chance that you will earn $50,000 p.a. over the remainder of your working life.

Assume that all cash flows (other than those specified otherwise) occur at year-end, are expressed in real terms (that is in terms of purchasing power today) and that the real opportunity cost of capital is 10%.

(a) Draw the decision tree relating to this problem.

(b) If you choose to do your PhD would you then choose to continue on to an academic career?

(c) Will you stay and do your PhD or leave and become a consultant?

(d) What is the implicit assumption made with respect to relative risk in this question?