QUESTION ONE

Platinum Real Estate Consulting Group, owner of a number of properties dotted around Lusaka is faced with a choice of:

1. A large-scale investment (A) to improve its flats. This could produce a substantial pay-off in terms of increased revenue net of costs but will require an investment of K1, 400,000. After extensive market research it is considered that there is a 40% chance that a pay-off of K2, 500,000 will be obtained, but there is a 60% chance that it will be only K800, 000.
2. A smaller scale project (B) to re-decorate its premises. At K500, 000 this is less costly but will produce a lower pay-off. Research data suggests a 30% chance of a gain of K1, 000,000 but a 70% chance of it being only K500, 000.
3. Continuing the present operation without change (C). It will cost nothing, but neither will it produce any pay-off. Clients will be unhappy and it will become harder and harder to rent the flats out when they become free.

REQUIRED:

1. Draw the decision tree representing the options open to Platinum Real Estate Consulting Group.
2. Calculate the expected values.
3. Calculate the net expected value.
4. How will a decision tree help the taking of the decision?

QUESTION TWO

An investor has the choice to accept a guaranteed K9 million cash inflow or an option with the following expectations:

• A 30% chance of receiving K7.5 million
• A 45% chance of receiving K15.5 million
• A 25% chance of receiving K4 million

Assume the risk-adjusted rate of return used to discount this option is 13.75% and the risk-free rate is 3.25%.

1. What is certainty equivalent and why is it important in financial risk management.
2. Calculate the expected cash flow of this investment.
3. Calculate the certainty equivalent cash flow.
4. If the investor prefers to avoid risk, what guaranteed option should accept?

QUESTION THREE

1. You are concerned about the possibility of experiencing on Coronavirus (COVID-19) during the next year. The probability of a COVID-19 outbreak is 0.5%. Your local insurer offers to pay you K300, 000 if a registered member of your family contracted COVID-19. The insurance policy costs K1, 500.00. If the inflation rate is forecast to be 10% during the next year, is the price of insurance policy fair.
2. A coin is biased so that it has a 60% chance of landing on heads. If it is thrown three times, find the probability of getting