Question

You are looking to invest in several different real estate deals. You have received ceconomic reports that explain the probability of good economic conditions will be .6 and .4 for bad economic conditions. Below is the Payoff Table, and after calculating the expected value for each decision, you determine the best "payoff deal is:

Good Economic Bad Economic
Conditions Condition (.60) Conditions (.40)
Apartment Building 50,000 30,000
Office Building $100,000 $-40,000
Warehouse 30,000 $10,000
A. Apartment Building
B. Office Building
C. Warehouse
D. None of the above.

Answer 1

Real Estate Deals

The best "payoff deal:"

B. Office Building

Explanation:

A) Payoff Table

Good Economic Bad Economic

Conditions Conditions

Probability (.60) (.40)

Apartment Building $50,000 $30,000

Office Building $100,000 $-40,000

Warehouse $30,000 $10,000

B) Calculation of Expected Values:

Good Economic Bad Economic Expected Values

Conditions Conditions

Probability (.60) (.40)

Apartment Building $30,000 $12,000 $42,000

Office Building $60,000 $-16,000 $44,000

Warehouse $18,000 $4,000 $22,000

b) The expected value for these real estate deals can be derived as the sum of the payoffs under the two economic conditions after they have been weighed with their odds of occurrence. The office building, in this example, showed the best payoff deal as the expected payoff from it results to a payoff of $44,000, which is higher than the expected payoff from the Apartment and Warehouse. However, it is also the riskiest, especially when bad economic conditions occur. This also accords with the general economic risk-return pattern that higher risky investments attract higher returns.