On the basis of his knowledge of current economic conditions and the outlook for the industry of EGI, Ted assesses the prior probability that EGI. will go bankrupt as 4%. If this happens, Ted will lose both principal and interest and will receive no money at the end of the year. If EGI. does not go bankrupt, Ted plans to sell the bonds, plus interest, at the end of one year. The probability that Canada Savings Bonds will fail to pay off is zero. Ted also plans to sell these, plus accrued interest, at the end of one year.

Ted is risk averse, and decides to choose the investment that yields the highest expected utility. Assume that Teds utility for an amount of $x is given by the square root of x, where x is the gross payoff (i.e. principal plus interest).

REQUIRED: On the basis of his prior probabilities, which investment should Ted choose? Rather than choosing on the basis of prior probabilities, assume that Ted decides to analyze the current financial statements of EGI. These financial statements can look good (G) or bad (B). After his analysis, Ted realizes that the statements look good. Ted knows that the probability that the financial statements would look good given that the firm was actually heading for bankruptcy is 0.09, that is: