Introduction to Management Science 12th Edition by Bernard Taylor

Exercise 9

Annie Hays recently sold a condominium she had bought and lived in while she was a college student over 15 years ago. She received $150,000 for the condominium and is considering two investment alternatives. Annie can invest the entire amount in a bank money market for 1 year at 8% interest and thus receive $162,000 at the end of a year, or she can invest in a speculative oil exploration project with a 50-50 chance of doubling her investment at the end of the year or losing everything.
a. Determine which alternative Annie should invest in, according to the expected value criterion, and indicate whether that is the alternative you would also select.
b. Suppose Annie determined that the probability of success for the oil exploration investment would have to be.80 before she would be indifferent between the two alternatives. In other words, if the probability of success for the oil exploration investment was less than.80, Annie would invest in the money market, but if the probability of success was greater than.80, she would invest in the oil exploration. In this case,.80 is the utility value of the $162,000 safe return. Determine the preferred alternative, according to the expected utility value.