You are one of several managers of a construction company. Your boss has put you

Question

You are one of several managers of a construction company. Your boss has put you in charge of $1M dollars, and it is your job how best to use the funds. One option is to invest the funds in T-Bills, which have an expected return of 5% no matter how well the economy performs. The other option is to use the funds to build an office building. Your business plan predicts that there is a 60% chance of an economic boom in which case the office building will be fully occupied yielding a sale price of $1,400,000 for the building. 40% of the time there will be a recession, however, leaving the building close to empty, and the sale price of building will be $500,000. You can assume the firm that you work for is risk neutral. a) What is the expected value of the office building? b) What is the expected (net) return on the office building? c) Based on your answer to part b, should you construct the building or invest irn T-Bills? d) Suppose you can hire Professor ÇOpelman to provide a 100% accurate macroeconomic forecast, which you would use to predict the occupancy rate of the building. Would you be willing to pay $20,000 for this forecast? Explain carefully why or why not. If you do buy the forecast, what will be the expected value of your investment? e) What is the most you would be willing to pay for Professor Copelman's services? Explain.

Explanation / Answer

Hi there !!

In this question we have to find out various things such as expected value of Investment, Expected return, which should be the better mode of investment etc.

We will proceed one by one..

First let us simplify the question by wrting down the key points as follows:

2. Expected Return of the Office building

3. The company should invest the funds in treasury bonds as the return is higher in the bonds as compared to return from investment in building.

4. Yes, you may buy the forecast services. Additional cost would be 20,000 $

New Expected Value of Investment will be = $10,40,000 - 10,00,000 - 20,000 = $ 20,000

5.  The maximum amount that can be paid for Coplemans services is the Net Return ie $ 40,000.

I hope the question is clear to you now...please go through and let me know if you face any further doubts....happy to help :)

All the best !!!

Amount Available for Investment $ 10,00,000 Option A Invest in Tbills Expected Return of 5% Option B Use the funds in an office building 60% Chance of Economic Boom Sale price        14,00,000 40% chance of Recession Sale price           5,00,000

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