Hanson Farms is considering an investment in equipment. Two possible types of eq
ID: 1202198 • Letter: H
Question
Hanson Farms is considering an investment in equipment. Two possible types of equipment are under consideration. The following estimates have been provide to them they are looking for your management team to make a recommendation to them. Bobcat Skidsteer Initial Investment $35,000 $35,000 Annual Rate of Return: Pessimistic 16% 10% Most Likely 18% 18% Optimistic 22% 32% a. What is the range of rates of return for each of the two pieces of equipment? b. Determine which project would be less of a risk and tell why. c. Which would you choose and which risk preference does that mean you have?
Explanation / Answer
The probability that is associated with each of the annual rate of return is 1/3, as there are three cases among which 1 will occur.
a. Therefore, the range of rates of return would be the range between lowest possible rate of return (the pessimistic one) and the highest possible rate of return (the optimistic one) associated with their respective probability.
For the 1st type of equipment: {(16% * 1/3), (22% * 1/3)} = {5.33%, 7.33%)
For the 2nd type of equipment: {(10% * 1/3), (32%, 1/3)} = {3.33%, 10.67%)
b. Now from the above derived range of the rates of return we could see that the percentage is not varying much for the 1st type of equipment, but it is highly variable for the 2nd type. That is, we could say that the type 1 equipment is less risky as the return would not fall much if it fails to give the optimistic rate of return; whereas for the type 2 equipment, the loss of return would be high if the equipment fails to give the optimistic rate of return.
c. Now, the piece of equipment that I would choose, would depend upon the expected return that I could get from purchasing the equipment. So, let us compute the expected returns for the two types of equipment--
The Expected Return for Type 1 Equipment = 5.33% * $35,000 + 6% * 35,000 + 7.33% * 35,000 = $6,531.
The Expected Return for Type 2 Equipment = 3.33% * $35,000 + 6% * $35,000 + 10.67% * $35,000 = $7,000
Since the expected return amount is greater for the type 2 investment, so I would recommend the company to for that.
Since, I am recommending type 2 equipment which is a bit more risky than the type 1, so I could be classified as risk lover. That is, I have tendency for going towards the risky investment.
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