Question

Kate wants to invest some money for a few years and is looking at several investment alternatives. The returns on her investment will largely depend on the state of the economy in the next few years. The various investment alternatives and their returns in the next few years are as follows: STATES OF NATURE DECISION (Economic Conditions) ALTERNATIVES Stable economy Favorable economy Unfavorable economy Stocks $250,000 $400,000 $ 155,000 Bonds $115,000 $175,000 $50,000 Money market fund $55,000 $75,000 $25,000 Real estate $150,000 $250,000 $85,000 Hedge fund $210,000 $325,000 $110,000 After a thorough analysis, Kate was able to estimate the probabilities for the three states of nature: P(stable economy) - 0.25; P(favorable economy) - 0.60; P(unfavorable economy) - 0.15. What is the Expected Value of Perfect Information (EVPI) for Kate? $27,000 $131,500 $75,250 $7,000 $306,250

Answer 1

Solution: The answer is $27,000.

Reason:

The expected value of perfect information = Expected value with perfect information (Note:1) - Expected value without perfect information (Note:2) = $27,000 ($306,250 - $ 279,250 )

Note:

1) Expected value with perfect information

Expected Value With Perfect Information
Alternatives	Stable Economy	Favorable Economy	Unfavorable Economy
Stocks	$              250,000	$                     400,000	$                        (155,000)
Bonds	$              115,000	$                     175,000	$                          (50,000)
Money market fund	$                55,000	$                        75,000	$                             25,000
Real estate	$              150,000	$                     250,000	$                          (85,000)
Hedge fund	$              210,000	$                     325,000	$                        (110,000)
Probability	0.25	0.6	0.15
Calculation	250000*0.25	400000*0.6	25000*0.15
Expected Value	$                62,500	$                     240,000	$                               3,750
Total			$                          306,250

Total Expected Value = Best Opportunity in the particular economy * Probability of that economy

2) Expected value without perfect information

Expected Value without Perfect Information
Alternatives	Stable Economy	Favorable Economy	Unfavorable Economy	Expected Value ( Value * Probability)
Stocks	$       250,000	$         400,000	$            (155,000)	$             279,250
Bonds	$       115,000	$         175,000	$              (50,000)	$             126,250
Money market fund	$         55,000	$           75,000	$                25,000	$               62,500
Real estate	$       150,000	$         250,000	$              (85,000)	$             174,750
Hedge fund	$       210,000	$         325,000	$            (110,000)	$             231,000
Probability	0.25	0.6	0.15

Expected value without perfect information is highest  of all expected values i.e., $279250 (Stocks)

3) Remaining Options are not correct.