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apricotdinosaur198Lv1

29 Sep 2019

Now, Dr. Pennyworth has a chance to purchase one of two professional cricket clubs, the Miami Manatees or the Jacksonville Gemini. At the beginning of last year, the Manatees were purchased for $100 million, provided $10 million in profits, and are currently on sale for $110 million. On the other hand, the Gemini started the year purchased at $80 million, provided $30 million in profits, and are currently on sale for $140 million. Calculate the rate of return for the owners of each team last year. Which team would you suggest that Dr. Pennyworth purchase today?

For the above problem, you project that the most optimistic profits for the Manatees this year is $35 million, while the most pessimistic projection is $5 million. Your projections for the Gemini are $32 million and $7 million, respectively. Based only on the range, which do you think is the riskier investment? Which one would you choose?

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Lelia LubowitzLv2

29 Sep 2019

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Finance homework check! Risk loving, calculations, etc. I just need my answers checked!

Suppose Joe has the choice of two investments. He can invest in a bond, which in 10 years (not accounting for inflation), will have a 50% probability of a 50% return and a 50% probability of a 40% return. On the other hand, he could invest in a mutual fund that in 10 years would have a 50% chance of returning 100% and a 50% chance of returning -20%. If he chose the latter investment, would he be considered Risk Neutral, Risk Averse, or Risk Loving?

Joe would be considered as risk loving.

The later investment is high risk high return investment compared to the one before.

Now, Dr. Pennyworth has a chance to purchase one of two professional cricket clubs, the Miami Manatees or the Jacksonville Gemini. At the beginning of last year, the Manatees were purchased for $100 million, provided $10 million in profits, and are currently on sale for $110 million. On the other hand, the Gemini started the year purchased at $80 million, provided $30 million in profits, and are currently on sale for $140 million. Calculate the rate of return for the owners of each team last year. Which team would you suggest that Dr. Pennyworth purchase today?

Miami Manatees

Investment =$100 million

Return = $10 million

Rate of return = 10/100 = 10%

Selling price = $110 million

Jacksonville Gemini

Investment = $80 million

Return = $30 million

Rate of Return = 30/80 = 37.5%

Selling Price = $140 million

Dr. Pennyworth should purchase Jacksonville Gemini cricket club.

For the above problem, you project that the most optimistic profits for the Manatees this year is $35 million, while the most pessimistic projection is $5 million. Your projections for the Gemini are $32 million and $7 million, respectively. Based only on the range, which do you think is the riskier investment? Which one would you choose?

Game	Most optimistic	Most pessimistic
Manatees	$35million	$5million
Gemini	$32 million	$7million

Based only on the range, Manatees is a riskier investment i.e. $30 million compared to $25million difference between the most optimistic and most pessimistic projection.

I would choose Manatees.

4. Imagine there are two free agent outfielders available. They both cost the same price, but you only have the money to sign one. Assume home runs alone are a proxy for performance. Suppose Player 1 has a 20% chance of hitting 20 home runs and a 20% chance of hitting 25 home runs, a 25% chance of hitting 30 home runs, a 20% chance of hitting 35 home runs, and a 15% chance of hitting 40 home runs. Player 2 has a 10% chance of hitting 10 home runs and a 10% chance of hitting 15 home runs, a 10% chance of hitting 25 home runs, a 30% chance of hitting 30 home runs, a 30% chance of hitting 35 home runs, and a 10% chance of hitting 50 home runs.

Which player has the highest expected return?

Player one expected return

0.2 *20 + 0.2*25 + 0.25*30 + 0.2*35 + 0.15*40 = 25.9 homes

Player two expected return

0.1*10+0.1*15+0.1*25+0.3*30+0.3*35+0.1*50= 24.5 homes

Which player would represent the riskier investment?

Player one
0.2	20	4	-25.5	650.25	130.05
0.2	25	5	-24.5	600.25	120.05
0.25	30	7.5	-22	484	121
0.2	35	7	-22.5	506.25	101.25

0.15	40	6	-23.5	552.25	82.8375
Expected return		29.5		VARIANCE	555.1875
				STD DEV	23.56

Player Two
0.1	10	1	-23.5	552.25	55.225
0.1	15	1.5	-23	529	52.9
0.1	25	2.5	-22	484	48.4
0.3	30	9	-15.5	240.25	72.075
0.3	35	10.5	-14	196	58.8
0.1	50	5	5	25	2.5
Expected return		24.5		VARIANCE	287.4
				STD DEV	16.95

Player 1 is a riskier investment i.e. Player 1 has higher variance and standard deviation

Which player would you choose?

I would choose player two

What does this say about your risk preferences?

I am risk loving

If there is a high chance of a negative return, why would a general manager invest in a very risky player? How might this conflict with the goals of the team as a whole?

A general manager would invest in a very risky player with a high chance of a negative return since probably the investment would generate huge profits if the estimation of the manager turns out to be correct is high.

The goals of the team as a whole are to maximize returns and minimize risk. Investing in a risky player raises the risk profile of the team as a whole.

Assume Mike Trout has the following distribution of outcomes for 2012. If he gets hurt, he will need some time to recover even while in the lineup, so he cannot produce at his highest level even if he comes back from an injury. If he does not get hurt, then he is certain to either Produce A, B or C, with A > B > C.

Outcome	Probability	Return/Production
Gets Hurt, Misses Whole Season	10%	0 wins
Gets Hurt, Misses 1/2 season, Produces B	20%	1.5 wins
Gets Hurt, Misses 1/2 season, Produces C	10%	0.75 wins
Gets Hurt, Misses 1/4 season, Produces B	10%	3 wins
Gets Hurt, Misses 1/4 season, Produces C	10%	1.5 wins
No Injury, Produces A	20%	10 wins
No Injury, Produces B	10%	6 wins
No Injury, Produces C	10%	3 wins

Using the above information, calculate Mike Trout's expected production for next year. What is his range of possible performances?

Outcome	Probability	Return/Production	Expected Return	Ri - ER	Ri - ER)SQUARED
Gets Hurt, Misses Whole Season	10%	0	0	-3.725	13.87563
Gets Hurt, Misses 1/2 season, Produces B	20%	1.5	0.3	-3.425	11.73063
Gets Hurt, Misses 1/2 season, Produces C	10%	0.75	0.075	-3.65	13.3225
Gets Hurt, Misses 1/4 season, Produces B	10%	3	0.3	-3.425	11.73063
Gets Hurt, Misses 1/4 season, Produces C	10%	1.5	0.15	-3.575	12.78063
No Injury, Produces A	20%	10	2	-1.725	2.975625
No Injury, Produces B	10%	6	0.6	-3.125	9.765625
No Injury, Produces C	10%	3	0.3	3.425	11.73063
Total expected Return			3.725
Variance					87.91188
Standard deviation					9.37

What about his standard deviation?

= 9.37

Using the standard deviation, calculate the interval within which Trout's performance should fall 95% of the time. Does anything seem strange about this calculation?

Standard error = 9.37/â (8) = 9.37/2.83 = 3.31

Margin of error = 3.31 x 2 = 6.61

95% confidence interval: 3.725 + 6.61 = -2.885 to 10.335

Something seems strange with this calculation. Margin of error is larger than the expected return

Suppose you could make an investment. With Investment 1, there is a 20% chance of making $10, a 15% chance of making $20, a 20% chance of making $25, a 20% chance of making $30, a 20% chance of making $40, and a 5% chance of making $100. For Investment 2, there is a 25% chance of making $1,000, a 50% chance of making $2,000, and a 25% chance of making $7,500. Use the coefficient of variation to evaluate the risk involved in these two investments. How does this result differ from using the range? How does it differ from comparing the two using only the standard deviation? Why is this important?

Investment 1		Expected return	Variance	Square of Variance
0.2	10	2	-27	729
0.15	20	3	-26	676
0.2	25	5	-1	1
0.2	30	6	-23	529
0.2	40	8	-21	441
0.05	100	5	-24	576
Expected Return		29
Variance				2952
STD Dev				54.33
Coefficient of variation = STD DEV/EXPECTED RETURN				1.8734

Investment 2		Expected return	Variance	Square of Variance
0.25	1000	250	-2875	8265625
0.5	2000	1000	-2125	4515625
0.25	7500	1875	-1250	1562500
Expected Return		3125
Variance				14343750
STD Dev				3787
Coefficient of variation = STD DEV/EXPECTED RETURN				1.2118

Range

Investment 2âs returns are more skewed than investment 1 and therefore investment two would be considered riskier. However, using coefficient of variation shows that investment 1 is riskier.

Standard deviation

Investment has a higher standard deviation compared to investment 1 and therefore investment two would be considered riskier. However, using coefficient of variation shows that investment 1 is riskier.

Coefficient of variation measures the variability of the outcomes relative to the expected return. Since the two sets of data are different, coefficient of variation is the best measure of risk.

Based on the following table of yearly revenues, do you think the two teams are compliments or substitutes? Why?

Year	Manatees	Gemini
2005	$10	$10
2006	$5	$15
2006	$15	$20
2008	$25	$35
2009	$12	$12
2010	$12	$15
2011	$20	$25

The teams are compliments. The price movements and range shows that Manatees and Gemini prices neither affect each other directly nor are they driven by the same set of factors as would be in the case of substitutes.

viridianhippopotamus258

In March 2015 the management team of Londonderry Air (LA) met to discuss a proposal to purchase five short haul aircraft at a total cost of $25 million. There was general enthusiasm for the investment, and the new aircraft were expected to generate an annual cash flow of $4 million for 20 years.

The focus of the meeting was on how to finance the purchase. LA had $20 million in cash and marketable securities (see table), but Ed Johnson, the chief financial officer, pointed out that the company needed at least $10 million in cash to meet normal outflow and as a contingency reserve. This meant that there would be a cash deficiency of $15 million, which the firm would need to cover either by the sale of common stock or by additional borrowing. While admitting that the arguments were finely balanced, Mr. Johnson recommended an issue of stock. He pointed out that the airline industry was subject to wide swings in profits and the firm should be careful to avoid the risk of excessive borrowing. He estimated that in market value terms the long-term debt ratio was about 59% and that a further debt issue would raise the ratio to 62%.

Mr. Johnson's only doubt about making a stock issue was that investors might jump to the conclusion that management believed the stock was overpriced, in which case the announcement might prompt an unjustified selloff by investors. He stressed therefore that the company needed to explain carefully the reasons for the issue. Also, he suggested that demand for the issue would be enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management's confidence in the future.

These arguments cut little ice with LA's chief executive. "Ed," she said, "I know that you're the expert on all this, but everything you say flies in the face of common sense. Why should we want to sell more equity when our stock has fallen over the past year by nearly a fifth? Our stock is currently offering a dividend yield of 6.5%, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. What's more, I don't see the point of paying out more money to the stockholders at the same time that we are asking them for cash. If we hike the dividend, we will need to increase the amount of the stock issue; so we will just be paying the higher dividend out of the shareholders' own pockets. You're also ignoring the question of dilution. Our equity currently has a book value of $12 a share; it's not playing fair by our existing shareholders if we now issue stock for around $10 a share.

"Look at the alternative. We can borrow today at 6%. We get a tax break on the interest, so the after-tax cost of borrowing is .65*6 = 3.9%. That's about half the cost of equity. We expect to earn a return of 15% on these new aircraft. If we can raise money at 3.9% and invest it at 15%, that's a good deal in my book.

"You finance guys are always talking about risk, but as long as we don't go bankrupt, borrowing doesn't add any risk at all. In any case my calculations show that the debt ratio is only 45%, which doesn't sound excessive to me.

"Ed, I don't want to push my views on this after all, you're the expert. We don't need to make a firm recommendation to the board until next month. In the meantime, why don't you get one of your new business graduates to look at the whole issue of how we should finance the deal and what return we need to earn on these planes?"

Evaluate Mr. Johnson's arguments about the stock issue and dividend payment as well as the reply of LA's chief executive. Who is correct? What is the required rate of return on the new planes?

Balance sheet
bank Debt	50	cash	20
other current liabilities	20	other current assets	20
10% bond, due 2032*	100	Fixed assets	250
Stockholders' equity**	120
Total liabilities	290	Total Assets	290
Income statement
Gross Profit	$57.5
Depreciation	20.0
Interest	7.5
Pretax profit	30.0
Tax	10.5
Net profit	19.5
Dividend	6.5

*the yield to maturity on LA debt is currently 6%

**LA has 10 million shares outstanding, with a market price of $10 a share. LA's equity beta s estimated at 1.25, the market risk premium is 8%, and the Treasury bill rate is 3%

Garnett Jackson, the founder and CEO of Tech Tune-Ups, stared t the window as he finished his customary peanut butter and jelly dwich, contemplating the dilemma currently facing his firm. ech Tune-Ups is a start-up firm, offering a wide range of com- ter services to its clients, including online technical assistance, ote maintenance and backup of client computers through the temet, and virus prevention and recovery. The firm has been 'ghly successful in the 2 years since it was founded; its reputation fair pricing and good service is spreading, and Mr. Jackson lieves the firm is in a good position to expand its customer base idly. But he is not sure that the firm has the financing in place to rt that rapid growth. Tech Tune-Ups' main capital investments are its own powerful mputers, and its major operating expense is salary for its consul- ts. To a reasonably good approximation, both of these factors w in proportion to the number of clients the firm serves. Currently, the firm is a privately held corporation. Mr. Jackson his partners, two classmates from his undergraduate days, have tributed $250,000 in equity capital, largely raised from their nts and other family members. The firm has a line of credit a bank that allows it to borrow up to $400,000 at an interest of 8%. So far, the firm has used $200,000 of its credit line. If when the firm reaches its borrowing limit, it will need to raise ity capital and will probably seek funding from a venture capi- firm. The firm is growing rapidly, requiring continual invest- t in additional computers, and Mr. Jackson is concerned that it approaching its borrowing limit faster than anticipated. 525 Mr. Jackson thumbs through past financial statements and esti- mates that each of the firm's computers, costing $10,000, can sup- port revenues of $80,000 per year but that the salary and benefits paid to each consultant using one of the computers is $70,000. Sales revenue in 2011 was $1.2 million, and sales are expected to grow at a 20% annual rate in the next few years. The firm pays taxes at a rate of 35%. Its customers pay their bills with an average delay of 3 months, so accounts receivable at any time are usually around 25% of that year's sales. Mr. Jackson and his co-owners receive minimal formal salary from the firm, instead taking 70% of profits as a "dividend," which accounts for a substantial portion of their personal incomes. The remainder of the profits are reinvested in the firm. If reinvested profits are not suffi- cient to support new purchases of computers, the firm borrows the required additional funds using its line of credit with the bank. Mr. Jackson doesn't think Tech Tune-Ups can raise venture funding until after 2013. He decides to develop a financial plan to determine whether the firm can sustain its growth plans using its line of credit and reinvested earnings until then. If not, he and his partners will have to consider scaling back their hoped-for rate of growth, negotiate with their bankers to increase the line of credit, or consider taking a smaller share of profits out of the firm until further financing can be arranged. Mr. Jackson wiped the last piece of jelly from the keyboard and settled down to work. Can you help Mr. Jackson develop a financial plan? Do you think his growth plan is feasible? Prepare a 700-1,050 word response, plus Excel spreadsheet, for the Mini-case at the end of Chapter 18 in Fundamentals of Corporate Finance (Brealey). Specifically, the Learning Team will need to follow all assumptions in the Mini-case precisely and carefully to complete the following: a. Identify the steps necessary to financially plan and forecast for 2005, 2006, and 2007, b. Project future years using the growth rate assumptions in the Mini-case, c. Determine what type and amount of financing may be required, taking into account the impact on leverage ratios, d. Determine the impact of rising interest rates on future performance, e. Assess alternative capital structures and impact on debt ratio and return on equity. f. Separately, after completing (a) through (e) above, explain how outsourcing certain cost of goods sold items would impact this planning and budgeting process.

maroonseal415

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