Economics of Risk and Uncertainty Applied Problems

Economics of Risk and Uncertainty Applied Problems

Please complete the following two applied problems. Show all your calculations and explain your results.

Problem 1:

A generous university benefactor has agreed to donate a large amount of money for student scholarships. The money can be provided in one lump sum of $12 million in Year 0 (the current year), or in parts, in which $7 million can be provided at the end of Year 1, and another $7 million can be provided at the end of Year 2.

Describe your answer for each item below in complete sentences, whenever it is necessary. Show all of your calculations and processes for the following points:

a. Assuming the opportunity interest rate is 8%, what is the present value of the second alternative mentioned above? Which of the two alternatives should be chosen and why?

PV of Future Amount = FVn / (1+r)^n

FV= $7,000,000

r=opportunity discount rate=0.08

n=number of year=1

PV= FVn / (1+r)^n

PV=7,000,000 / (1+0.08)^1

PV= $6,481,481.48

PV= FVn / (1+r)^n

PV=7,000,000 / (1+0.08)^2

PV= $6,001,371.74

= $12,482,853.22

The second alternative should be chosen because it is more by $482,853.22.

b. How would your decision change if the opportunity interest rate is 12%?

PV= FVn / (1+r)^n

PV =7,000,000 / (1+0.12)^1

PV= $6,252,000.00

PV= FVn / (1+r)^n

PV= 7,000,000 / (1+0.12)^2

PV= $5, 580,357.14

=$11,834,357.14

My decision would not change because the higher rate yields a smaller amount.

c. Provide a description of a scenario where this kind of decision between two types of payment streams applies in the “real-world” business setting.

One scenario payments can be delayed. For example, there’s an agreement for a payment from March 2015 to be paid in March 2016. I would be getting the principal in the first year and then interest the following. Another example is if I purchased property and sold it and received a full payment today. I would receive more if I waited for the final payment to be made years...