Chapter 15 – Applied Problems

1. Consider a firm that is deciding whether to operate plants only in the United States or also in either Mexico or
Canada or both. Congress is currently discussing an overseas investment in new capital (OINC) tax credit for U.S.
firms that operate plants outside the country. If Congress passes OINC this year, management expects to do well if
it is operating plants in Mexico and Canada. If OINC does not pass this year and the firm does operate plants in
Mexico and Canada, it will incur rather large losses. It is also possible that Congress will table OINC this year and
wait until next year to vote on it. The profit payoff matrix is shown here:

States of Nature
OINC Passes OINC Fails OINC Stalls
Operate plants in US only $10 million -$1 million $2 million
Operate plants in US and Mexico 15 million -4 million 1.5 million
Operate plants in US, Mexico and Canada 20 million -6 million 4 million

Assuming the managers of this firm have no idea about the likelihood of congressional action on OINC this year,
what decision should the firm make using each of the following rules?

a. Maximax rule

Under Maximax strategy, firm will operate plants in US, Mexico, Canada.

b. Maximin rule

Under Maximin rule, firm will operate plants in US only.

c. Minimax regret rule

Calculating the potential regret matrix as:

States of Nature
OINC Passes OINC Fails OINC Stalls
Operate plants in US only $10 million 0 $2 million
Operate plants in US and Mexico 5 million 3 million 2.5 million
Operate plants in US, Mexico and Canada 0 5 million 0

The bolded numbers represent the maximum potential regrets.

Thus, the Minimax regret rule will be to either to operate in US and Mexico or operate in US, Mexico and Canada.

d. Equal probability rule

First calculating the average payoffs as:

Operate plants in US only (10 – 1 + 2)/3 = 3.7 million

Operate plants in US and Mexico (15 – 4 + 1.5)/3 = 4.2 million
Operate plants in US, Mexico and Canada (20 – 6 + 4)/3 = 6 million

So, as per the equal probability rule, the firm will operate in US, Mexico and Canada

2. Suppose your company’s method of making decisions under risk is “making the best out of the worst possible
outcome.” What rule would you be forced to follow?

When a company’s method of making decisions under risk is to make the best out of the worst situation, the rule that
it needs to follow is the maximin rule which focusses on getting maximum output from minimum or worst situations.
This rule helps in adopting different strategies so as to come out of an unfavorable situation to achieve the best
possible results.
3. “A portfolio manager needs to pick winners—assets or securities with high expected returns and low risk.” What
is wrong with this statement?

High returns can only be achieved when a person is taking high risk because there is a direct relation between risk and
return in portfolio management. In the given question it is written that a portfolio manager needs to pick winners with
high returns and low risk, which is not at all possible, as one cannot get high returns without undertaking high risk.

4. Remox Corporation is a British firm that sells high-fashion sportswear in the United States. Congress is currently
considering the imposition of a protective tariff on imported textiles. Remox is considering the possibility of moving
50 percent of its production to the United States to avoid the tariff. This would be accomplished by opening a plant
in the United States. The following table lists the profit outcomes under various scenarios:

Profit Margins
No Tariff Tariff
Option A: Produce all output in Britain $1,200,000 $800,000
Option B: Produce 50% in the US 875,000 1,000,000

Remox hires a consulting firm to assess the probability that a tariff on imported textiles will in fact pass a
congressional vote and not be vetoed by the president. The consultants forecast the following probabilities:

Probability
Tariff will pass 30%
Tariff will fail 70%

a. Compute the expected profits for both options.

Calculating the expected profit for both the options as below:

Option A: 0.3(800,000) + 0.7(1,200,000) = 240,000 + 840,000 = 1,080,000

Thus, expected profit of option A = $1,080,000

Option B: 0.3(1,000,000) + 0.7(875,000) = 300,000 + 612,500 = 912,500

Thus, expected profit of option B = $912,500

b. Based on the expected profit only, which option should Remox choose?

Since expected profit in case of option A is higher, the firm will choose option A.

c. Compute the probabilities that would make Remox indifferent between options A and B using that rule.

For the firm to be indifferent between options A and B, the expected profits from both the options must be the same.
That is,

P(1,200,000) + (1 – P)(800,000) = P(875,000) + (1 – P)(1,000,000)

400,000P + 800,000 = -125,000P + 1,000,000

P = 0.38

Where, P is the probability that the tariff fails; 1-P is the probability that the tariff passes.

Thus, P = 0.38 and 1-P = 0.62

d. Compute the standard deviations for options A and B facing Remox Corporation.

Using the formula of standard deviation as:

Substituting values to get:

Option A:

Thus, standard deviation for option A = 183,303.3

Option B:

Thus, standard deviation for option B = 57,282.2

e. What decision would Remox make using the mean–variance rule?

Since option A has both high-risk and high-return, the mean-variance rule cannot be used

f. What decision would Remox make using the coefficient of variation rule?

Calculating the coefficient of variation for both the options as below:

Since the coefficient of variance is lower for option B, the firm would chose option B

5. Using the information in Applied Problem 4, what decision would Remox make using each of the following rules
if it had no idea of the probability of a tariff?

a. Maximax

In case of Maximax, firm will prefer to have production in Britain only rather than transferring to USA because profit
margin is high in Britain as compared to USA. Therefore, Option A

b. Maximin

In case of Maximin, firm will chose to produce 50% of the goods in United States. Therefore, Option B

c. Minimax regret

In case of Minimax regret, firm will prefer to have production in Britain only rather than transferring to USA because
profit margin is high in Britain as compared to USA. Therefore, Option A

d. Equal probability criterion

In case of Equal probability criterion, firm will prefer to have production in Britain only. Therefore, Option A.
6. Return to Applied Problem 1 and suppose the managers of the firm decide on the following subjective
probabilities of congressional action on OINC:

Probability
OINC passes 40%
OINC fails 10%
OINC stalls 50%

a. Compute the expected profits for all three decisions.

E(Profit)US = $4.9 million

E(Profit)US, Mexico = $6.35 million

E(Profit)US, Mexico, Canada = $9.4 million

b. Using the expected value rule, which option should the managers choose?

Using the expected value rule, the firm should operate plants in the US, Mexico, and Canada.

c. Compute the standard deviations for all three decisions. Using the mean–variance rule, does any one of the
decisions dominate? If so, which one?

The standard deviations are, respectively, 4.25, 7.24, and 9.12. None of the three options dominates by mean-variance
rules.

d. What decision would the firm make using the coefficient of variation rule?

υUS = 0.87

υUS,M = 1.14

υUS,M,C = 0.97

Under the coefficient of variation rule, the firm should operate only in the US.