Certainty Equivalent Method. Saddie Hawkins, a management analyst with Mobile Telephone Services, Inc., has collected the following information about three investment projects undertaken by the firm during the past six month period. Hawkins wishes to use this information as a backdrop against which to evaluate the attractiveness of a recent investment proposal put forth by the quality control department. In that proposal, dubbed Project X, the quality control department proposes to spend $100,000 to modify transmission equipment at the Colorado Springs, Colorado facility. Annual expected cost savings of $25,000 per year over the 10-year 2005-2014 period have been projected, and verified as reasonable by Hawkins.
A. Calculate the present value of anticipated cost savings using an 8% discount rate as a reasonable estimate of the risk-free cost of capital.
B. In light of the $100,000 investment required for each of these projects, and the discounted present value of future benefits, calculate the certainty equivalent adjustment factor a implicit in the decision to fund each of these investment projects.
C. Assume that the a's implicit in the decisions to fund projects Y and Z represent the upper limits for investment projects of this type. Would a decision to fund project X be consistent or inconsistent with the firm's decision to fund projects Y and Z?

Question

Certainty Equivalent Method. Saddie Hawkins, a management analyst with Mobile Telephone Services, Inc., has collected the following information about three investment projects undertaken by the firm during the past six month period. Hawkins wishes to use this information as a backdrop against which to evaluate the attractiveness of a recent investment proposal put forth by the quality control department. In that proposal, dubbed Project X, the quality control department proposes to spend $100,000 to modify transmission equipment at the Colorado Springs, Colorado facility. Annual expected cost savings of $25,000 per year over the 10-year 2005-2014 period have been projected, and verified as reasonable by Hawkins.
  A. Calculate the present value of anticipated cost savings using an 8% discount rate as a reasonable estimate of the risk-free cost of capital.
B. In light of the $100,000 investment required for each of these projects, and the discounted present value of future benefits, calculate the certainty equivalent adjustment factor a implicit in the decision to fund each of these investment projects.
C. Assume that the a's implicit in the decisions to fund projects Y and Z represent the upper limits for investment projects of this type. Would a decision to fund project X be consistent or inconsistent with the firm's decision to fund projects Y and Z?

Quizplus · Accepted Answer

The Answer of Certainty Equivalent Method. Saddie Hawkins, a management analyst with Mobile Telephone Services, Inc., has collected the following information about three investment projects undertaken by the firm during the past six month period. Hawkins wishes to use this information as a backdrop against which to evaluate the attractiveness of a recent investment proposal put forth by the quality control department. In that proposal, dubbed Project X, the quality control department proposes to spend $100,000 to modify transmission equipment at the Colorado Springs, Colorado facility. Annual expected cost savings of $25,000 per year over the 10-year 2005-2014 period have been projected, and verified as reasonable by Hawkins.
  A. Calculate the present value of anticipated cost savings using an 8% discount rate as a reasonable estimate of the risk-free cost of capital.
B. In light of the $100,000 investment required for each of these projects, and the discounted present value of future benefits, calculate the certainty equivalent adjustment factor a implicit in the decision to fund each of these investment projects.
C. Assume that the a's implicit in the decisions to fund projects Y and Z represent the upper limits for investment projects of this type. Would a decision to fund project X be consistent or inconsistent with the firm's decision to fund projects Y and Z?