Suppose a firm predicts that demand for its good will either be high or low and its costs will either be higher than expected or lower than expected. If demand for the good is high, the firm expects $10 million in revenue. If demand is low, revenue will be $7 million. On the cost side, if costs are higher than expected, total cost will be $12 million. If costs are lower than expected, then $8 million. Suppose the probability demand will be high is 0.70. Probability demand will be low is 0.30. Additionally, the probability that costs will be high is 0.25 and the probability that costs will be low is 0.75. Assume all events are independent. Draw the tree diagram for these outcomes and calculate the expected return on the investment. Potentially, the firm could lose $5 million (if demand is low and costs are higher than expected). Given this, assuming the firm can participate in hundreds of markets similar to this one, should it (i.e. would it be profitable)? Explain why in terms of the expected value. What is risk aversion?
Calculating Expected Return from a Risky Project
Firms and individuals often face investment situations that are dependent on multiple possible outcomes, each with specific probabilities or likelihoods. The appropriate choice in such situations will depend on expected returns and investor attitudes toward risk.
Answer and Explanation:
The decision tree diagram is below. The right-hand boxes in the diagram show the profit and loss outcomes that the firm faces and the probabilities of...
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from Introduction to Management: Help and ReviewChapter 2 / Lesson 12