Final answer:
To evaluate the risk of two investments for Questa Bank, you calculate the expected value and standard deviation for each investment's net cash flows. The one with a lower standard deviation is typically considered less risky.
Step-by-step explanation:
The question is asking to evaluate the risk of two different investments by Questa Bank based on their possible net cash flows (NCF) and associated probabilities. To assess the risk and advise the management on the course of action to take, we can calculate the expected value and the standard deviation of the net cash flows for both Investment I and Investment II.
Expected Value (EV) is calculated by multiplying each possible NCF by its probability and then summing all these products. The formula for EV is:
EV = Σ (Possible NCF × Probability)
The Standard Deviation (SD) measures the amount of variability or dispersion from the expected value. It is calculated by taking the square root of the variance. Variance is calculated by squaring the difference between each possible NCF and the expected value, multiplying by the probability of the NCF, and summing these products. The formula for SD is:
SD = √[Σ (Probability × (Possible NCF - EV)²)]
After calculating the EV and SD for both investments, the investment with the lower SD would typically be considered lower risk. The management should also consider their risk tolerance and investment goals when choosing between Investment I and Investment II.
The complete question is: Questa Bank is intending to invest in two different investments with the following net cash flows. Investment I Investment II Possible NCF Probability Possible NCF Probability (KES) (KES) 3600 20% 2400 20% 4400 60% 3400 60% 4700 20% 4400 20% Evaluate the risk of the two investments and advise the management on the course of action to take is: