Analysis of Risky Investments - Systematic and Idiosyncratic Risk - Accounting and Finance Assignment Help

Assignment Task :

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 topics listed below.

1. The various types of risk, such as systematic and idiosyncratic risk, that arise in the context of insurance and the analysis of risky investments. How do these risks affect the opportunity cost of capital associated with a particular firm or investment? 

2. The concepts of a call option and a put option. How can options be used by large investors such as pension funds to limit the risk of a fall in the prices of the stocks and bonds in their portfolio?

3.  The hold-up problem. How is the hold-up problem related to the difficulty in writing complete contracts? Why might a merger between a firm and its supplier be a solution to the hold-up problem? 

4. any other concept which was discussed in the course and which you believe to be interesting and important. For each topic that you discuss, clearly explain the concepts involved in each topic. Also discuss why the topic is important for financial decision making and/or 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 3 explain why the topics are important. A well written, well organized essay is also likely to earn a higher grade.

Part B. 

Problem Part of the Essay Assignment

A group of investors owns a lease to exploit a deposit of copper at a particular location. There are two periods, period 0 and period 1. The investors must decide whether to develop the copper mine in period 0, in period 1, or not at all. All profits and costs are expressed in millions of pounds and represent present values in period 0 whether or not they are incurred in period 0 or period 1. 

If the investors develop the mine in period 0, then they must pay a development cost, D = 440, in period 0. By developing the mine in period 0, the investors also obtain the profit V0 = 120 in period 0 as well as a profit from the mine obtained in period 1. 

From the perspective of period 0, the profit from a developed mine in period 1 is uncertain due to uncertainty in the price of copper. Suppose that there is a probability of 1/2 that the price of copper in period 1 will be high. In this case, the present value of the profit obtained from the mine in period 1 will take the high value VH = 500. With probability 1/2 the price of copper will be low, and the present value of the profit from the mine in period 1 will take the low value VL = 160. 

For simplicity, we assume that the investors acquired the lease to exploit the copper sometime in the past. Hence, the cost to the investors of purchasing the lease, L, has already been sunk and does not affect their decision of when to develop the mine or whether to develop the mine at all. 

The investors have three choices in period 0. 

1. The investors can choose to develop the copper mine in period 0. 

2. The investors can choose in period 0 not to develop the mine either in period 0 or period 1. If the investors choose not to develop the mine, the investors receive a net present value of 0 since they obtain no profit but also pay no cost. 

3. The investors can choose to defer the decision as to whether or not to develop the mine until period 1.

 Questions 

(a) Draw a decision tree representing the decision problem facing the investors.

 (b) What is the optimal sequence of choices for the investors to make? Justify your answer. 

(c) Now suppose that, before any development decision is made in period 0, the volatility of the price of copper increases. Specifically suppose that the increase in uncertainty in the price of copper increases the value of VH from VH = 500 to VH’ = 560. The increased uncertainty also decreases the value of VL from VL = 160 to VL’ = 100. 5 For simplicity, assume that the change in the volatility of the price of copper does not change any other parameters of the problem including the probability (i.e. 1/2) that the price of copper is high in period 1.

 A financial analyst warns the investors that the increased volatility in the price of copper is likely to reduce the value of their lease to develop the deposit of copper.

 Would you agree or disagree with the analyst’s warning? Explain your reasoning. 

(d) A second financial analyst observes that, since the investors already have the lease to develop a copper mine, they should always develop the mine immediately, that is, in period 0, as long as the expected present value of the profit from developing the mine in period 0, V0 + (VL + VH )/2 , is greater than the development cost D.

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