Economics of Risk and Uncertainty Applied Problems

Question 1 - University Benefactor

a) Present Value Of The Second Alternative

According to Kimmel et al (2007), PV = FVn/ (1+r) n. In this case, r is the opportunity rate, n is the number of years and FV is future value. Applying the formula to the second alternative would result to PV of $10,000,000 + $5.5m/ (1.06) + $5.5m/ (1.06) (1.06) = $5.18m + $4.89m = $10,070,000. Hence; Present value of the second alternative would be $10.07m

b) Choosing Between The Two Alternatives

In deciding between the two alternatives, I will consider the present value of both alternatives after two years.

The PV of first alternative is $10m, while the PV of second alternative is $10.07m. In this case, the second alternative exceeds the first alternative with $70,000. Therefore, the second alternative should be chosen at it offers maximum benefits to the university.

c) Increase Of The Opportunity Interest Rate To 12%

The PV of the second alternative would be $5.5m/ (1.12) + $5.5m/ (1.12) (1.12) + $4.91m + $4.38m = $9,290,000.

In this case, the first alternative is the best for the university. Clearly, my decision will have changed after the increase of the opportunity interest rate to 12%.

Question 2 - Angel Investor

a) Coefficient Of Variation Decision Criterion

Primarily, the coefficient of variation is used to measure the relative risk. Coefficient of variation = standard deviation/ expected return


Coefficient of variation for Business 1 = 40,000/100,000 = 0.4

Coefficient of variation for business 2 = 25,000/60,000 = 0.4167

The angel investor is risk averse meaning that he or she wishes to avoid or minimize the risk involved in an investment; hence, he will chose business 1 which has a low risk probability.

b) Maximin Criterion

In maximin criterion, the decision maker is expected to select the alternative that offers the best of the worst possible outcomes (Lu et al., 2012)

The minimum worst outcome of business 2 is a profit of $5,000, while the minimum worst outcome of business 1 is a loss of $5,000.

Worst OutcomesProfit
Business 1 Business 2
$5,000 -$5,000

According to the maximin criterion, the best option is business 2 because it offers the best of the worst possible outcomes.

c) Certainty Of An Angel Investor

If I am the angel investor, I believe I am risk-neutral. Primarily, I am only interested on the expected returns and not the dispersion of the returns.



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