Financial Risk and Return Considerations Essay Sample
1. [ Financial Risk and Return Considerations ] Explain how you would take between the undermentioned state of affairss. Develop your replies from the position of the rules of entrepreneurial finance presented earlier in the chapter. You may get at your replies with or without doing existent computations.
A. You have $ 1. 000 to put for one twelvemonth ( this would be a luxury for most enterprisers ) . You can gain a 4 % involvement rate for one twelvemonth at the Third First bank or a 5 % involvement rate at the First Fourth bank. Which savings history investing would you take and why?
Third First bank: $ 1. 000 ten 1. 04 = $ 1. 040
First Fourth bank: $ 1. 000 ten 1. 05 = $ 1. 050
The First Fourth bank loan would be preferred because you would have $ 10 more ( $ 1. 050 versus $ 1. 040 ) at the terminal of one twelvemonth. This illustration illustrates the rule: “real. human. and fiscal capital must be rented from proprietors. ” The clip value of money is an of import constituent of the rent one wage for utilizing person else’s fiscal capital.
B. A “friend” of yours will impart you $ 10. 000 for one twelvemonth if you agree to refund him $ 1. 000 involvement plus returning the $ 10. 000 investing. A 2nd “friend. ” has merely $ 5. 000 to impart to you but wants entire financess of $ 5. 400 in refund at the terminal of one twelvemonth. Which loan would you take and why?
First friend: $ 1. 000/ $ 10. 000 = 10 % involvement rate
Second friend: $ 400/ $ 5. 000 = 8 % involvement rate
The 2nd friend is offering you a lower involvement rate ( 8 % versus 10 % ) which would be preferred. other things being equal. This illustration illustrates the rule: “real. human. and fiscal capital must be rented from proprietors. ” The clip value of money is an of import constituent of the rent one wage for utilizing person else’s fiscal capital.
However. the dollar sum of fiscal that is needed besides must be considered. For illustration. if you “need” $ 10. 000 so the lower involvement rate $ 5. 000 loan is non a feasible option. The lone feasible pick might be to borrow $ 10. 000 at the 10 per centum rate of involvement.
C. You have the chance to put $ 3. 000 in one of two investings. The first investing would pay you either $ 2. 700 or $ 3. 300 at the terminal of one twelvemonth depending on the success of the venture. The 2nd investing would pay you either $ 2. 000 or $ 4. 000 at the terminal of one twelvemonth depending on the success of the venture. Which investing would you take and why? Now. would your reply alteration if your investing were merely $ 1?
Low ResultHigh ResultExpected Value
First investing: $ 2. 700 $ 3. 300 ( $ 2. 700 + $ 3. 300 ) /2 = $ 3. 000 Second investing: $ 2. 000 $ 4. 000 ( $ 2. 000 + $ 4. 000 ) /2 = $ 3. 000
A 2nd rule of entrepreneurial finance is: “risk and expected wages travel manus in manus. ” “Risk” is reflected in the scattering or scope of results. Each investing sum is $ 3. 000 and the expected return on norm is $ 3. 000 for each investing. However. the 2nd investing is considered to be riskier in that you might really have merely $ 2. 000 or two-thirds of your investing at the terminal of one twelvemonth. Since the investing sums and expected values are the same. risk-averse investors would prefer the first investing because it has less scattering hazard.
However. when investings are really little ( or are perceived to be little by a specific investor ) . some investors might do the riskier investing in the “hope” the highest return will happen. This is sometimes called the “lottery” consequence in that investors know there is a high chance that they will lose all of their investing but they are willing to set about the investing in the hope they will have the high final payment even though the odds of making so are really. really little.
Bankruptcy or failure state of affairss may besides do the investor ( enterpriser ) to take the riskier investing. For illustration. let’s assume that you will necessitate $ 3. 500 in order to maintain your concern afloat. Since merely the riskier 2nd investing has the possibility of paying at least $ 3. 500. the 2nd investing might be selected.
D. An outside venture investor is sing puting $ 100. 000 in either your new venture or in another venture. or put $ 50. 000 in each venture. At the terminal of one twelvemonth. the value of the venture might be either $ 0 or $ 1. 000. 000. The other venture is expected to be deserving either $ 50. 000 or $ 500. 000 at the terminal of one twelvemonth. Which investing pick ( yours. the other venture. or half-and-half ) do you believe the venture investor would take to put in? Why?
Low ResultHigh ResultExpected Value
Your venture: $ 0 $ 1. 000. 000 ( $ 0 + $ 1. 000. 000 ) /2 = $ 500. 000 Other venture: $ 50. 000 $ 500. 000 ( $ 50. 000 + $ 500. 000 ) /2 = $ 275. 000
Half-and-half: $ 25. 000 $ 750. 000 ( $ 25. 000 + $ 750. 000 ) /2 = $ 387. 500
Under the half-and-half option. $ 50. 000 is invested in each venture. The low consequence result is $ 25. 000 ( $ 0 + $ 25. 000 ) and the high consequence result is $ 750. 000 ( $ 250. 000 + $ 500. 000 ) . In actuality there are two more possible results under the half-and-half option. They are: $ 250. 000 ( $ 0 + $ 250. 000 ) and $ 525. 000 ( $ 25. 000 + $ 500. 000 ) . Therefore. the more complete half-and-half computation would be: ( $ 25. 000 + $ 250. 000 + $ 525. 000 + $ 750. 000 ) /4 = $ 387. 500.
A venture investor who is non really risk averse might take your venture to put in since there is a possibility of having $ 1. 000. 000 in return for seting up $ 100. 000. Of class. such an investor could lose all of his/her investing if the low consequence occurs. A more hazard averse venture investor might take to put in merely the other venture where he/she could lose merely $ 50. 000 of the $ 100. 000 investing if the low consequence occurs with the possibility of having a upper limit of $ 500. 000 if the high consequence possibility occurs.
By uniting the two venture investings in a “portfolio. ” the consequence is frequently less scattering hazard. In the above illustration. the lowest sum
returned would be $ 25. 000 ( alternatively of nothing for merely your venture ) . However. the highest sum returned besides would be lower at $ 750. 000 ( alternatively of the possibility of $ 1. 000. 000 for your venture ) . The concluding determination will depend on the venture investor’s willingness to merchandise off a lower expected return for less scattering hazard.