Question

A construction company plans to invest in a building project. there is a 30% chance that the company will lose $30,000, a 40% chance of a break even, and a 30% chance of a $60,000 profit. based on this information, what should the company do?

Answer 1

Answer:

Holding all other factors constant, the company should invest in the building project since the expected value of the project is a $ 9000 profit.

Explanation:

Scenario analysis is done when companies need to make decisions based on possible financial outcomes of a project or investment. The expected value of a project or investment would tell investors whether they are taking on a suitable level of risk given the likelihood of the anticipated return. The anticipated return is calculated as follows using the expected value formula:

Expected value (X) = Sum of [P(Xₙ) *Xₙ] where P is the probability of an event occurring(chance of occurrence and X is the event itself (Project outcome).

The expected value of the building project: $9, 000

Event              Probability     Event Value      Event Outcome

Loss                30% (0.03)     -($30,000)           -($9000) (0.03* -($30,000))

Break-even     40% (0.04)     $0                        $0 (0.04 *$0)

Profit               30% (0.03)     $60,000              $18,000 (0.03 * $60, 000)

Expected Value                                                    $9,000

Given that the expected value of the project is positive, the company would take on the project holding all other factors constant. However, in a real world setting factors such as the company's risk profile, investment portfolio performance as well as whether the projected profit would meet their stipulated required rate of return, would have to be considered before the final decision to invest was made.

Answer 2

Based on this information, there is a a 30% chance of the company losing money and a 70% chance that they do not lose any money. However, there is also only a 30% chance that the company gains any profits from this deal. I would recommend that the company not invest in this building project as the rate of return is not high enough compared to the risk of no return.