Diversification and its relation to the opportunity cost of capital
i. the concept of diversification and its relation to the opportunity cost of capital. ii. the concept of a call option. iii. Draw a decision tree for analyzing a practical investment decision.
The essay should not be more than 3000 words in length.
For each concept that you discuss, clearly explain the concept.
Also discuss why the concept is important for financial decision making and the analysis of investments.
Your grade for the traditional essay component will be based in part on (i) how clearly you explain the concepts you choose to discuss and (ii) how well you
explain why the concepts are important for financial decision making in general and for the analysis of investments.
You must not quote from any source without explicitly acknowledging that source.
Kindly refer to the specific questions about the decision tree from the uploaded pdf file.
Please be thorough and be time sensitive as i might not have enough time to go through the paper before the submission deadline.
BU5596: International Finance 2019 J. Swierzbinski
Course Assessment – Essay Assignment.
Instructions
The essay part of the assessment for BU5596 International Finance consists of two parts – a problem and a traditional essay component. The combined essay assignment is worth 80 % of the total mark for the course. The remaining 20 % of the marks for the assessment are based on an in-class
quiz held on Wednesday 27 February.
The problem part of the essay assignment is worth 25 % of the grade for the essay assignment. The traditional essay component is worth 75 % of the total marks for the essay assignment. The essay assignment is an individual assignment. You may use whatever books, lecture notes, etc. you wish, but
you may not discuss either part of the essay assignment with anyone. In particular, you should not discuss either part of the assignment with
other students. Nor should you read another student’s assignment. You may ask me questions about the assignment.
For full-time students, the essay assignment must be submitted no later than 10:00 AM, Monday, 4 March 2019.
For part-time students, the essay assignment must be submitted no later than 10:00 AM, Monday, 11 March 2019.
Two paper copies of the essay assignment should be submitted. The traditional essay component of the essay assignment must be typed. The problem part of the essay assignment, which involves a decision tree, does not need to be typed. However, it should be written neatly and clearly. In order to grade the assignment, I must be able to read it.
For the paper copies, fasten both the problem part and the traditional essay component together with a stapler or other fastener before
submitting it. The paper copies should be submitted in the box labeled PGT Management near the Business School office on the second floor of the
Edward Wright Building. Click on the Assessment link of the My Aberdeen course webpage to download a copy of the cover sheet that should be
attached to each paper copy.
In addition, a copy of the traditional essay component must be submitted via Turnitin. See the regulations governing School Policies on
MyAberdeen for more details. Also, click on the Assessment link on the MyAberdeen course webpage. You do not have to submit the problem part of
the essay via Turnitin.
Note. If you have questions about either the format or content of the assignment, you should contact Prof. Joseph Swierzbinski.
Part A. Traditional Essay Component of the Essay Assignment (75 % of the total mark)
The traditional essay component of the essay assignment should not be more than 3000 words in length.
I would like you to write an essay discussing at least two and not more than three of the four concepts listed below.
i. the concept of diversification and its relation to the opportunity cost of capital.
ii. the concept of the law of one price and the idea of arbitrage.
iii. the concept of a call option.
iv. any other concept which was discussed in the course and which you believe to be interesting and important.
For each concept that you discuss, clearly explain the concept.
Also discuss why the concept is important for financial decision making and the analysis of investments.
Your grade for the traditional essay component will be based in part on (i) how clearly you explain the concepts you choose to discuss and (ii) how well you
explain why the concepts are important for financial decision making in general and for the analysis of investments. A well written, well organized
essay is also likely to earn a higher grade.
Part B. Problem Part of the Essay (25 % of the total mark) An investor (a venture capitalist) is considering whether or not to set up a
company to produce a new product. There are two periods, period 0 and period 1. The investor must decide whether to set up the company in period 0,
in period 1, or not to set up the company at all.
If the investor sets up the company in period 0, then the investor must pay a setup cost with a present value of F = 450 in period 0. In addition to paying
this cost, the investor will receive the net present value produced by the company in period 0, V0 = 100, and the net present value V1 produced in period 1. The net present values V0 and V1 include the revenue obtained from the sale of the new product minus varying operating costs and taxes.
However, as is common practice, these present values do not include the setup cost, F, which is specified as a separate item in this paragraph.
For simplicity, we also assume that setting up the company is instantaneous, so that the new product can be produced in the same period that the company
is set up. Note that the cost of setting up the company, F, is paid only in the period in which the company is first set up.
3
From the perspective of period 0, the net present value V1 produced by the company in period 1 is uncertain because of uncertainty in the future demand for the new product. The investor believes that there is a 50% chance that the
demand for the new product will be high at the beginning of period 1. In other words, there is a probability of 0.5 that the demand for the new product is high in period 1. In this case, the net present value produced by the company in
period 1 will take the high value VH = 600.
With probability 0.5, the demand for the new product will be low in period 1. In this case, the net present value produced by the company in period 1 will take
the low value VL = 150.
.
Suppose, for simplicity, that the net present value produced by the company in period 1 is the same whether the company is set up in period 0 or in
period 1. Suppose also that the present value of the cost setting up the company, F, is the same whether the company is set up in period 0 or in
period 1.
All numerical values for the net present values produced by the company and for the cost of setting up the company, F, are present values denominated in millions of pounds.
Suppose also that the investor is risk neutral and wishes to maximise the expected net present value of the opportunity to set up the company
(including the cost of setting up the company and, if necessary, the cost of the marketing study described below).
The investor has three choices in period 0. (i) The investor can choose to pay the setup cost F in period 0 and set up the company immediately in period 0.
(ii) The investor can choose in period 0 to abandon the opportunity to set up the company in either period 0 or period 1. In this case, the investor neither
receives nor loses anything and so obtains an expected net present value of 0. (iii) The investor can choose to defer the decision to setup the company
until period 1 and, in period 0, commission a marketing study to determine whether or not the demand for the new product will be high or low in period 1.
Let M indicate the present value of the cost of the marketing study. The cost M must be paid at the beginning of period 0.
By deferring the decision to setup the company and commissioning the marketing study, the investor learns whether or not the net present value
obtained by setting up the company in period 1 will be high or low before having to decide whether or not to pay the setup cost F to set up the company
in period 1. Of course, by choosing to wait until period 1, the investor also loses the net present value V0 that could have been produced by the company in period 0.
Suppose that the investor needs the results of the marketing study to know whether the demand for the new product will be high or low before he or she
must decide whether to set up the company in period 1. Hence, it makes no 4 sense for the investor in this example to defer the decision to set up the
company until period 1 unless the investor also commissions the marketing study.
Questions
(i) Draw a decision tree representing the decision problem facing the investor.
(ii) Suppose that M = 30 million pounds. What is the optimal policy for the investor to follow? Carefully explain your answer.
(iii) For what positive values of M would the investor’s optimal choice be to commission the marketing study and wait until period 1 to decide whether or not to set up the company? Carefully explain your reasoning.
(iv) Suppose now, for simplicity, that the cost of the marketing study is negligible. In particular, let M = 0. To what extent would you agree that, if
M = 0, then, for any positive values of V0, VH and VL, it would always be optimal to commission the marketing study and wait until period 1 to decide
whether or not to set up the company? Explain your answer.
(v) Continue to suppose that M = 0. To what extent would you agree that the expected net present value obtained by choosing to commission the
marketing study and wait until period 1 to decide whether or not to set up the company would always be at least as large as the expected net present value obtained by choosing in period 0 to abandon the opportunity to set up the company in either period 0 or period 1? Explain your answer. To what extent
does your explanation depend on the assumption that M = 0?
End of Questions.
Plagiarism. Plagiarism is taken very seriously by the University. You should read the section on plagiarism in the course booklet and the school policy on
Academic Integrity and ask me if you have any questions.
You must not quote from any source without explicitly acknowledging that source. If you copy from a source without a proper reference it is likely that Turnitin or I will detect it, and the consequences for you could be severe.
See the guidelines for reference and citation in the course booklet and the reference to the library guide to referencing and citation in the school policy
section on Academic Integrity.
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