Explain how you would choose between the following situations. Develop your answ

Question

Explain how you would choose between the following situations. Develop your answers from the perspective of the principles of entrepreneurial finance presented earlier in the chapter. You may arrive at your answers with or without making actual calculations.

1. You have $1,000 to invest for one year (this would be a luxury for most entrepreneurs). You can earn a 4% interest rate for one year at the Third First bank or a 5% interest rate at the First Fourth bank. Which savings account investment would you choose and why?

2. A “friend” of yours will lend you $10,000 for one year if you agree to repay him $1,000 interest plus returning the $10,000 investment. A second “friend,” has only $5,000 to lend to you but wants total funds of $5,400 in repayment at the end of one year. Which loan would you choose and why?

3. You have the opportunity to invest $3,000 in one of two investments. The first investment would pay you either $2,700 or $3,300 at the end of one year depending on the success of the venture. The second investment would pay you either $2,000 or $4,000 at the end of one year depending on the success of the venture. Which investment would you choose and why? Now, would your answer change if your investment were only $1?                

4. An outside venture investor is considering investing $100,000 in either your new venture or in another venture, or invest $50,000 in each venture. At the end of one year, the value of the venture might be either $0 or $1,000,000. The other venture is expected to be worth either $50,000 or $500,000 at the end of one year. Which investment choice (yours, the other venture, or half-and-half) do you think the venture investor would choose to invest in? Why?

Explanation / Answer

Answer 1 :

Third first bank interest rate @ 4% & First fourth bank has interest rate of 5%.

If we invest $ 1000 in Third First Bank for 1 year, we get Interest after one year:

1000 X 4% = $40

So, total return after one year would be $1040 (1000+40).

If we invest $ 1000 in Fifth Fourth Bank for 1 year, we get Interest after one year:

1000 X 5% = $50

So, total return after one year would be $1050 (1000+50).

Conclusion : We should invest in Fifth fourth bank as the return is higher in this case.

Answer 2 :

Alternative 1 : Borrow $10,000 today & repay $11,000 (10,000 + 1000) after 1 year.

Alternative 2 : Borrow $5,000 today & repay $5,400 (5000 + 400) after 1 year.

Formula:   Interest = Principal X Interest Rate

So,              Interest Rate = Interest / Principal

In alternative 1,

                   Interest Rate = 1000/10000 = 10%

In alternative 2,

                   Interest Rate = 400/5000 = 8%

Conclusion: Since Borrowing cost is less in alternative 2, we should choose alternative 2.

Answer 3 :

Alternative 1: First investment would pay either $2700 or $3000 at the end of one year.

Alternative 2: Second investment would pay either $2000 or $4000 at the end of one year.

From the above data, we can conclude that Alternative 1 has more stable return than Alternative 2. i.e. alternative 2 has more fluctuation. More fluctuation means more risk & parameter for measurement of risk is standard deviation. So we can say, That alternative should be selected which has a lower standard deviation i.e. that has lower risk.

Alternative 1 has standard deviation of 150, while alternative 2 has standard deviation of 1000.

Conclusion : Alternative 1 should be opted, since it has lower standard deviation. Answer remains same even if investment were only $1.

Answer 4 :

Alternative 1: Invest $1,00,000 in new venture.

Alternative 2: Invest $1,00,000 in another venture.

Alternative 3: Invest $50,000 in alternative 1 & $50,000 in alternative 2.

On the basis of same reasoning of “Answer 3”, that alternative which has lower Standard Deviation should be opted.

Alternative 1 has standard deviation of 5,00,000, while alternative 2 has standard deviation of 2,25,000 & alternative 3 has SD of 2,01,750.154

Conclusion : Alternative 3 should be opted, since it has lower standard deviation.

Note 1: Standard deviation of alternative 3 is computed by assigning 50% weightage to each alternative’s average income.

Note 2: Full calculation of standard deviation is not calculated as the question demanded only principles of finance should be presented, actual calculations are not mandatory.

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