Question

Sharon​ Smith, the financial manager for Barnett​ Corporation, wishes to evaluate three prospective​ investments: X,​ Y, and Z. Sharon will evaluate each of these investments to decide whether they are superior to investments that her company already has in​ place, which have an expected return of

15​%

and a standard deviation of

4​%.

The expected returns and standard deviations of the investments are as​ follows:

Investment Expected Return Standard Deviation

X 15% 6%

Y 13% 7%

Z 17% 5%

 a.  If Sharon were risk​ neutral, which investment might she​ select?  

b.  If she were risk​ averse, which investment might she​ select?

c.  If she were risk​ seeking, which investments might she​ select?  

d.  Given the traditional risk preference behavior exhibited by financial​ managers, which investment might be​ preferred?  

Answer 1

Answer a.

The risk-indifferent manager would accept Investment Z because it has higher returns than the 15% required return and the risk doesn’t matter.

Answer b.

The risk-averse manager would accept Investment Z because it provides the highest return and has the lowest amount of risk. Investment Z offers an increase in return for taking on more risk than what the firm currently earns.

Answer c.

The risk-seeking manager would accept Investment Y because he or she is willing to take greater risk without an increase in return.

Answer d.

Traditionally, financial managers are risk-averse and would choose Investment Z, since it provides the required increase in return for an increase in risk.