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If it is managed efficiently,Luther Industries will have assets with market value of $100 million,$300,million,or $500 million next year,with each outcome being equally likely.Managers may,however,engage in wasteful empire building which will reduce the firm's market value by $20 million in all cases.Managers may also increase the risk of the firm,changing the probability of each outcome to 50%,20%,and 30% respectively.
-If it is managed efficiently,then the expected market value of Luther's assets is closest to:

Question

Quizplus · Accepted Answer

The expected market value of Luther's assets is the weighted average of the market values of the three outcomes, where the weights are the probabilities of each outcome. If the managers do not engage in empire building or increase the risk of the firm, then the expected market value is:

(1/3)($100 million) + (1/3)($300 million) + (1/3)($500 million) = $300 million

If the managers engage in empire building, then the expected market value is reduced by $20 million in all cases. Therefore, the expected market value becomes:

(1/3)($100 million - $20 million) + (1/3)($300 million - $20 million) + (1/3)($500 million - $20 million) = $240 million

If the managers increase the risk of the firm, then the probabilities of each outcome change to 50%, 20%, and 30%. Therefore, the expected market value becomes:

(0.5)($100 million) + (0.2)($300 million) + (0.3)($500 million) = $260 million

Since the managers may or may not engage in empire building or increase the risk of the firm, the expected market value with the most likely outcome is still $300 million. Therefore, the best choice is A) $300 million.

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