Question

Your company wants to decide between Investment A, which will cost $300K upfront, and Investment B, which will cost $250K upfront. If the economy performs well, Investment A will bring in $850K for your company, but if the economy performs poorly, then it will lose $400K for your company. If the economy performs well, Investment B will bring in $900K for your company, but if the economy performs poorly, then it will lose $500K for your company. There’s a 60% chance of a strong market and a 40% chance of a weak market. Draw the decision tree and calculate the EMV for both investment A and B.

Answer 1

To decide between Investment A and B, we calculate the Expected Monetary Value (EMV) for each, considering a 60% chance of a strong economy and a 40% chance of a weak one. Investment A has an EMV of $350K, whereas Investment B has an EMV of $340K. Based on EMV, Investment A is the preferred option.

Step-by-step explanation:

Decision-Making in Investments:

Your company wants to decide between Investment A, which will cost $300K upfront, and Investment B, which will cost $250K upfront. both investments have different returns based on the economic performance. to make a decision, we need to draw a decision tree and calculate the expected Monetary Value (EMV) for each.

Calculating EMV for Investment A:

If the economy performs well (60% chance), Investment A will bring in $850K. If the economy performs poorly (40% chance), it will lose $400K. The EMV for Investment A is calculated as: EMV(A) = (0.6 × $850K) + (0.4 × -$400K) = $510K - $160K = $350K.

Calculating EMV for Investment B:

If the economy performs well, Investment B will bring in $900K. If it performs poorly, it will lose $500K. the EMV for Investment B is: EMV(B) = (0.6 × $900K) + (0.4 × -$500K) = $540K - $200K = $340K.

The EMV is higher for Investment A than for Investment B. Thus, based on the EMV, Investment A would be the preferred choice for the company.