Question

Mr. Manning is looking to invest in a one-year stock option and has four possible options. The four options have various rates of return based on whether or not the market rises or fall within the coming year. After consulting with his financial planner, he has the following estimates based on the various market outcomes:
Stock Market Rising Market Stable Market Falling
SUA $68,082 $47,373 $36,362
YSP $64,850 $49,320 $44,865
HTC $57,198 $52,949 $50,605
YHA $59,766 $59,766 $59,766

Mr. Manning’s planner has estimated that the probability the market rises is 60%, stays stable is 30%, and falls is 10%. To assist Mr. Manning in his decision, build a decision tree to model the decision and answer the following question. You do not need to upload your decision tree for this question.

Required:
a. Which stock is the best expected value decision and what is the expected value of that decision?
b. Which stock is the worst expected value decision?

Answer 1

Answer:

Mr. Manning

a. YHA is the best expected value decision with an expected value of $59,766.

b. HTC is the worst expected value decision.

Explanation:

a) Data and Calculations:

Stock    Market Rising    Market Stable    Market Falling

SUA          $68,082              $47,373              $36,362

YSP           $64,850             $49,320              $44,865

HTC           $57,198             $52,949              $50,605

YHA          $59,766             $59,766              $59,766

Expected Value:

Stock     Market Rising    Market Stable    Market Falling   Expected Value

Probability    60%                   30%                   10%

SUA          $68,082*60%   $47,373*30%    $36,362*10%     =  $58,697

YSP          $64,850*60%   $49,320*30%    $44,865*10%     =     58,163

HTC          $57,198*60%   $52,949*30%    $50,605*10%     =   55,264

YHA         $59,766*60%   $59,766*30%    $59,766*10%     =   59,766

SUA = $40,849.20 + $14,211.90 + $3,636.20 = $58,697.30

YSP = $38,880 + $14,796 + $4,486.50 = $58,162.50

HTC = $34,318.80 + $15,884.70 + $5,060.50 = $55,264

YHA = $35,859.60 + $17,929.80 + $5,976.60 = $59,766