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this decision. Indeed, the expected value of perfectinformation concerning plant efficiency was close tozero. Based on these results, the managers decidedto research the uncertainties regarding by-productquantity and the level of impurities before commit-ting to the construction of the new plant.Expected Value of Perfect InformationConcerning Factors Influencing Whether toBuild New Chemical PlantFactorExpected Value ofPerfect Information(Millions of Dollars)By-product quantity6.2Level of impurities3.9Raw material costs0.3Plant efficiency0.0PROBLEM SOLVED:Evaluating an Investment in a New Chemical Plant1.A certain profit of $2,000,000.2.A gamble with a 50–50 chance of a $4,100,000 profit or a $60,000 loss.The expected profit for the gamble is0.50($4,100,000)+0.50(-$60,000)=$2,020,000so managers should choose the gamble over the certainty of $2,000,000 if theywant to maximize expected profit. However, it seems likely that many manag-ers, especially those of small businesses, would prefer the certainty of $2,000,000because the gamble entails a 50% chance that the firm will lose $60,000—a sub-stantial sum for a very small firm. Moreover, many managers may feel they can doalmost as much with $2,000,000 as with $4,100,000, and therefore the extra profitis not worth the risk of losing $60,000.Whether the firm’s managers will want to maximize the expected profit in thissituation depends on their attitude toward risk. If the amount at stake in adecision
544CHAPTER 14: RISK ANALYSISAs is typical of all publicly traded companies afterSarbanes-Oxley, FedEx tells investors and potentialinvestors about its exposure to market risk. Such dis-closure was caused by the failure to provide informationabout the true exposure to risk in the Enron, Tyco,and WorldCom cases.FedEx states, “We have no significant exposureto changing interest rates on our long-term debtbecause interest rates are fixed on the majority of ourlong-term debt.” With respect to a $500 million debtwith a floating interest rate that was to mature inAugust 2007, FedEx stated that it did not employ inter-est rate hedging to mitigate the risks with respect tothis borrowing. The company’s reasoning was that a10% increase in the interest rate on its outstandingfloating-rate debt would not have a material effecton its results of operations. On May 31, 2007, it hadan estimated fair value $2.4 billion in outstand-ing fixed-rate, long-term debt. The market risk forsuch debt (estimated to be $36 million as of May 31,2006) was estimated as the potential decrease infair value resulting from a 10% increase in interestrates.FedEx also disclosed its risk due to currencyfluctuations. Most of its transactions were denomi-nated in U.S. dollars, but it had significant transac-tions in the euro, Chinese yuan, Canadian dollar,British pound, and Japanese yen. FedEx stated that“distribution of our foreign currency denominatedtransactions is that such currency declines in someareas of the world are often offset by currency gainsin other areas of the world.” In fact, during 2006 and2007, FedEx believed that operating income was

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Term
Fall
Professor
Blecherman
Tags
Supply And Demand, Textbook, Sula, managerial behavior

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