Question

Wilson Motors is looking to expand its operations by adding a second manufacturing location. If it is​ successful, the company will make ​$430 comma 000. If it​ fails, the company will lose ​$290 comma 000. Wilson Motors is trying to decide whether it should borrow the ​$290 comma 000 given the current bank loan rate of 12​%. Should Wilson Motors borrow the money ifa.  the probability of success is 91​%?b.  the probability of success is 85​%?c.  the probability of success is 75​%?

Answer 1

(a) Wilson Motors should borrow the money.

(b) Wilson Motors should not borrow the money.

(c) Wilson Motors should not borrow the money.

Explanation:

(a) If the probability of success is 91​%?

Expected return = 0.91*$430,000 + 0.09*(-$290,000)

= 391,000 - 26,100

= $364,900

Cost = $290,000*(1+12%)

= $324,800

Expected profit = Expected return - Cost

= $364,900 - $324,800

= $40,100

Since it results in profit, Wilson Motors should borrow the money.

(b) If the probability of success is 85​%?

Expected return = 0.85*$430,000 + 0.15*(-$290,000)

= 365500 - 43,500

= $322,000

Cost = $290,000*(1+12%)

= $324,800

Expected profit = Expected return - Cost

= $322,000 - $324,800

= -$2800

Since it results in loss, Wilson Motors should not borrow the money.

c) If the probability of success is 75​%?

Expected return = 0.75*$430,000 + 0.25*(-$290,000)

= 322500 - 72,500

= $250,000

Cost = $290,000*(1+12%)

= $324,800

Expected profit = Expected return - Cost

= $250,000 - $324,800

= -$74800

Since it results in loss, Wilson Motors should not borrow the money.

Answer 2

a = 27400 ( borrow)

b = -21600 ( do not borrow)

c = -84600 ( do not borrow)

Explanation:

a) Success probability = 88%

Expected payout = 88($430,000) + 0.12(-$270000) = $34600

Cost of borrowing = $270000(1+ 0.18) = 318600

EXPECTED PROFIT = 27400 you can borrow.

b) Probability of success is 81%

Expected payout = 0.18($430000) + 0.19(-$270000)

= $297,000

Cost of borrowing = $270000 (1+0.18) = 318600

Expected loss = -21600 do not borrow

c) Probability of of success = 72%

Expected payout = 0.72($430000) + 0.28(-$270000) = $234000

Cost of borrowing = $270000(1+ 0.18) = 318600

Expected loss = -84600 do not borrow