Question

Martin International has borrowed $50 million from several financial institutions. The CEO of the company is considering three investment options with this borrowed money: expand production; invest in stocks; or buy deposit certificates. The return from expanding production or investing in stocks depends on whether the economy continues to boom or enters a recession. The CEO estimates that there is a 40% chance of a recession. She also estimates that: > expanding production will generate a positive return of 15% if the economy continues to boom and a loss of 10% if the economy enters recession; > investing in stocks will generate a positive return of 12% if the economy continues to boom and a loss of 5% if the economy enters recession; and > investing in bank deposit certificates will generate a positive return of 6% independent of economic conditions.

a. What decision should the CEO make if she uses the maximin strategy?

Explain. b. What decision should the CEO make if she uses the maximax strategy?

Explain. c. What decision should the CEO make if she wants to maximize the expected profit of the investment? Explain.

Answer 1

Part A)

The worst outcomes are:

Expanding production - Loss of 10%

Investing in stocks - Loss of 5%

Deposit certificates - Profit of 6%

Hence we need to maximise the minimum loss. Hence in such a case we choose to invest in bank deposit certificates.

Part B)

The best outcomes are:

Expanding production - Profit of 15%

Investing in stocks - Profit of 12%

Deposit certificates - Profit of 6%

The maximum of the maximum benefit is Expanding Production. Hence the CEO should choose to expand production.

Part C)

The expected profits are:

Expanding production: E(P) = 0.6*15% + 0.4(-10%) = 5%

Investing is stocks: E(P) = 0.6*12% + 0.4(-5%) = 5.2%

Deposit certificates: E(P) = 0.6*6% + 0.4*6% = 6%

Hence deposit certificates have highest expected profit. Hence the CEO will choose to invest in deposit certificates.