Question

1. XYZ Corp is expected to exist for two years. It is trying to decide whether to take action A, B, or C. The finance team produced the following characteristics of the firm’s annual cash flows under the three options:

Option	Expected Value	Stdev	Skewness	Beta
A	$100	$35	-1.5	1.2
B	$100	$25	1.2	1.4
C	$105	$35	-1.0	1.5

             Assume the annual risk-free return is 2 percent and the annual market risk-premium is five percent. The firm’s objective is to maximize its value. For each pair of options, what are key tradeoffs? That is, identify the advantages and disadvantages of A vs. B. Do the same for B vs. C and A vs. C. Are there options that you would rule out? Briefly explain.

Answer 1

1) A vs B

Advantage: If A is selected, the beta is 1.2 which mean the A is less volatile to the market when compared to B

if B is selected, the standard deviation is 25 when comapred to A, which mean the risk assumed is less.

Disadvantage: If A is selected, the the standard deviation is more when compared to B

if B is selected, the option B is more volaitie to market.

2) A vs C

Advantage: If A is selected, the beta is 1.2 which mean the A is less volatile to the market when compared to C.

Disadvantage: if C is selected, the option B is more volaitie to market which is 50% more volatile

The standard deviation is same for both the options and therefore and be ruled out in this comparison.

3) B vs C

  .Advantage: if B is selected, the standard deviation is 25 when compared to C which mean the risk assumed is less and the option C is 10% less volatile to the marekt when comapred to option C.

Disadvantage: If C is selected, the risk assumed and the volatality to the market is higher when compared to the option B.