Economics Assignment 1

Economics of Risk

Tina Schneider

Managerial Economics

Dr. Thomas Badley

March 28, 2016

Problem 1

Present value of alternative

Given that the alternative to receiving $12 million immediately (in year zero) is to receive $7 million at the end of year one and $7 million at the end of your two, assuming the provided interest rate of 8%, the present value of the alternative is $12.48 million. The formula used to find this is PV=7/(1.08)+7/(1.08)^2= $12.48 million with 7 being the installment amount, 1.08 representing the opportunity interest rate, and 2 representing the 2nd year of installment.

Based on present value of the $7 million installment option with an interest rate of 8%, the better choice for the university is the two $7 million installments. This is because the value of the funds is more than that of the $12 million initial option given in one lump sum in year zero.

Opportunity interest rate of 12%

Given that the alternative to receiving $12 million immediately (in year zero) is to receive $7 million at the end of year one and $7 million at the end of your two, assuming the provided interest rate of 12%, the present value of the alternative is $11.83 million. The formula used to find this is PV = 7/ (1.12) + 7/ (1.12) ^2 = $11.83 million. This uses the opportunity interest rate of 1.12 as opposed to the 1.08 used in the initial alternative investigated above.

Based on present value of the $7 million installment option with an interest rate of 12%, the better choice for the university is the one lump sum of $12. This is because the value of the funds given in installments is less than that of the $12 million initial option given in one lump sum in year zero.

Real-world scenario

An example of a real-world business setting where this kind of decision between two types of payment streams applies is the scenario where an auto parts company has to make the decision to allow its large wholesale customers to pay for bulk parts using a line of...