Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wi

Question

Risk preferences Sharon Smith, the financial manager for Barnett Corporation,
wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm
earns 12% on its investments, which have a risk index of 6%. The expected return
and expected risk of the investments are as follows:
a. If Sharon were risk-indifferent, which investments would she select? Explain why.
b. If she were risk-averse, which investments would she select? Why?
c. If she were risk-seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers,
which investment would be preferred? Why?

Explanation / Answer

a. The risk-indifferent manager would accept Investments X and Y because these have higher returns than the 12% required return and the risk doesn’t matter. b. The risk-averse manager would accept Investment X because it provides the highest return and has the lowest amount of risk. Investment X offers an increase in return for taking on more risk than what the firm currently earns. c. The risk-seeking manager would accept Investments Y and Z because he or she is willing to take greater risk without an increase in return. d. Traditionally, financial managers are risk-averse and would choose Investment X, since it provides the required increase in return for an increase in risk.

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