Certainty Equivalents. Rabbit Food, Inc., is a rapidly growing chain of health food restaurants. The company has a limited amount of capital for expansion, and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Fresno and/or Pasadena, California. Projections for the two potential outlets are:
Each restaurant would involve a capital expenditure of $2.5 million, plus land acquisition costs of $500,000 for Fresno and $1.5 million for Pasadena. The company uses the 10% an estimate of a minimal risk-free annual opportunity cost of investment capital.
A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution.
B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet.
C. Assuming the management of Rabbit Food is risk averse, and uses the certainty equivalent method in decision making, which is the more attractive outlet? Why?

Question

Certainty Equivalents. Rabbit Food, Inc., is a rapidly growing chain of health food restaurants. The company has a limited amount of capital for expansion, and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Fresno and/or Pasadena, California. Projections for the two potential outlets are:
  Each restaurant would involve a capital expenditure of $2.5 million, plus land acquisition costs of $500,000 for Fresno and $1.5 million for Pasadena. The company uses the 10% an estimate of a minimal risk-free annual opportunity cost of investment capital.
A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution.
B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet.
C. Assuming the management of Rabbit Food is risk averse, and uses the certainty equivalent method in decision making, which is the more attractive outlet? Why?

Quizplus · Accepted Answer

The Answer of Certainty Equivalents. Rabbit Food, Inc., is a rapidly growing chain of health food restaurants. The company has a limited amount of capital for expansion, and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Fresno and/or Pasadena, California. Projections for the two potential outlets are:
  Each restaurant would involve a capital expenditure of $2.5 million, plus land acquisition costs of $500,000 for Fresno and $1.5 million for Pasadena. The company uses the 10% an estimate of a minimal risk-free annual opportunity cost of investment capital.
A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution.
B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet.
C. Assuming the management of Rabbit Food is risk averse, and uses the certainty equivalent method in decision making, which is the more attractive outlet? Why?