A private investment company has three available investment opportunities. They are: investment in real estate development, investment in retail franchise, and investment in a restaurant franchise. Each of the opportunities will pay off in ten years. However, the company has just enough money to invest in only one of the opportunities and needs to choose the best out of the three. Therefore, the investment opportunities are mutually exclusive. The expected value method is used to evaluate and rank the three investment opportunities according to their returns and riskiness. The opportunity with the largest expected value and hence least risk is selected for investment. It is worth noting that the opportunity with the lowest expected value is selected if the conditional values are expressed as costs Mian (2011). However, the conditional values of the present case scenario are expressed as net present values.
Expected value, also referred to as expected monetary value when the variables involved are in monetary terms as is the case in the present case scenario, is the weighted average of the possible monetary values as weighted by their respective probabilities. According to Mian (2011, P. 132), the expected monetary value can also be defined as the mean of the probability distribution of all possible monetary outcomes of an event. The different monetary outcomes and their probabilities of occurrence are required to compute the expected monetary value. The payoffs are multiplied by their probabilities of occurrence and the products summed to arrive at the expected monetary value.
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The raw data for the three investment opportunities has been provided in a different excel sheet. It shows that each opportunity has three possible return outcomes, which are high, medium, and low returns. The probabilities of occurrence for each outcome under each opportunity are also provided in the excel sheet. For instance, the probabilities that investing in the real estate will yield high, medium, and low returns are 0.5, 0.35, and 0.15 respectively. The high, medium, and low payoffs are $4,500,000, $2,750,000, and $75,000 respectively. The probability of occurrence and its respective expected payoff are multiplied to obtain the return’s weight. The high, medium, and low returns yield weights of $2,250,000, $962,500, and $11,250 respectively. The expected monetary value of the investment opportunity is obtained by summing up the three weights. The sum is $3,223,750.
The probabilities that investing in the ‘Just Hats’ retail franchise will yield high, medium, and low returns are 0.55, 0.30, and 0.15 respectively. The payoffs under the high, medium, and low return conditions for the project are $5,000,000, $3,250,000, and $425,000 respectively. Therefore, the weights for the high, medium, and low returns are $2,750,000, $975,000, and $63,750 respectively. The sum of the three weights, which is $3,788,750, is the opportunity’s expected monetary value.
The probabilities that investing in the ‘Cupcakes and so forth’ restaurant franchise will yield high, medium, and low returns are 0.55, 0.35, and 0.10 respectively. The expected returns under each of the three conditions are $4,250,000, $3,000,000, and $225,000 respectively. The products of the expected returns and their respective probabilities, which are the weights of the different conditions, are $2,337,500, $1,050,000, and $22,500 respectively. The sum of the weights, which is $3,410,000, is the investment opportunity’s expected monetary value.
As stated in the introductory paragraph above, the investment company has enough money to invest in only one opportunity. The ‘Just Hats’ retail franchise opportunity has the highest expected monetary value and is, therefore recommended for investment. The discussion for the different attitudes towards risk may also be used to justify the choice of the retail franchise opportunity. According to Drury (2005, p. 214), the three possible attitudes towards risk are aversion, indifference, and desire for risk or risk-seeking. The investment company may use the different expected monetary values to rank the three opportunities according to their levels of risk. For instance, the opportunity in real estate has the lowest expected monetary value and thus the highest level of risk while the ‘Just Hats’ opportunity has the highest expected monetary value and hence the lowest level of risk. The ‘Cupcakes and so forth’ project has a medium expected monetary value and hence a medium level of risk. Risk seekers prefer the riskiest investment opportunities. In the present case scenario, a risk-seeking investor would prefer the opportunity in real estate. A risk avert investor prefers the least risky opportunity. In the present case scenario, risk avert investors would select the ‘Just Huts’ opportunity. A risk indifferent/neutral investor would select any of the three opportunities. Drury (2005, p. 214) further states a majority of investors are risk-averse and hence chose the least risky investment opportunities. This is the justification for choosing the ‘Just Hats’ opportunity; the least risky of the three alternatives.
The use of the expected monetary value to rank opportunities and select the best for investment has been discussed in the present essay. The method is easy to use and apply. However, investors should be aware of some of its shortcomings when using it to rank investment opportunities. For instance, according to Kaplan Financial Limited (2012), it is possible that the expected monetary value will not correspond to any actual possible outcome. It is also not possible to determine the accuracy of the probabilities used to compute the expected monetary value (Kaplan Financial Limited, 2012). Finally, the method can only be used as an effective decision criterion for many similar sized projects, such as the ones in the present case scenario.
- Drury, C. (2005). Management Accounting for Business (3rd ed., p. 214). London: Cengage Learning.
- Kaplan Financial Limited. (2012). Kaplan Financial Limited. Retrieved from http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Expected%20Values%20(EV).aspx
- Mian, M. (2011). Project Economics and Decision Analysis (2nd ed., p. 132). Tulsa: OK: PennWell Books.
