Personal finance. A young engineer is planning ahead for her retirement. She has saved $10,000 and has three investment choices open to her: (1) a corporate bond with a 10 year maturity, (2) common stock in a corporation that she has been following, and (3) a stock mutual fund. Her estimates of the compound annual rates of return and their associated probabilities are shown in the table below. In each case she has decided that the investment will not be touched for 10 years.
Investment | Rate of Return (%) | Probability |
Corporate bond | 7 | 1.0 |
Corporate stock | 15 | 0.4 |
| 5 | 0.3 |
| -5 | 0.2 |
| -15 | 0.1 |
Mutual fund | 10 | 0.3 |
| 5 | 0.4 |
| -5 | 0.3 |
(a) Determine the best investment strategy. Draw the complete decision tree, showing all probabilities. payoffs, expected values, and so on, What is the expected return on the optimal investment?
(b) The engineer learns that management is about to change in her closely watched individual corporation. The new management is known to favor larger dividend payouts to holders of common stock. It' this occurs, it will not only increase the annual rate of return on the Stock bur will also make the stock more attractive to investors, driving up the price in the long run, further increasing the compound rate of return. The engineer revises her probability estimates for the corporate stock investment as shown in the table below. Draw the complete decision free for this new situation and determine the optimal strategy and associated expected annual rate of return.
|
| Probability of Achieving the Rate of Return Shown | |||
Dividend Action | Probability | 15% | 5% | -5% | -15% |
Raise | 0.7 | 0.50 | 0.35 | 0.10 | 0.05 |
Same | 02 | 0.40 | 0.30 | 0.20 | 0,10 |
Lower | 0.1 | 0.30 | 0.20 | 0.30 | 0.20 |
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