Question

[Same investments as the prior question] Suppose two local start-ups are raising funding by issuing shares of equity at $10,000 per share. One start-up is a whiskey distillery; the other is a beer brewery. You estimate the expected returns on your investment to be 50% over five years in both cases. You also believe that the likelihood of being paid out $20,000 per share is greater with the distillery than with the brewery. Suppose now that you hold a portfolio of many other risky assets, and that this would be your N 1 investment. Which investment do you prefer to make, the distillery or the brewery

Answer 1

Answer:

you should purchase the brewery's stock

Explanation:

First of all, as investors we should always try to maximize our returns while avoiding risks. It is really hard to balance both, but we must compare stocks to see which may represent a higher gain while posing the lesser or same risk.

• Initial investment in each = $10,000 (equal for both)
• expected returns over 5 years = $5,000 (equal for both)
• but there is a higher possibility of the distillery's stock being more valuable, and that makes a difference.

Both stocks seem equally risky, but they are not. When you calculate expected returns, you multiply the possible returns by their probability. I'm not sure how they calculated the expected returns of the above stocks, but the following can help you understand my point:

stock B                        return         probability        expected return

great                             100%             25%                    25%

normal                            50%             50%                    25%

bad                                  0%              25%                     0%

total                                                   100%                    50%

stock D                        return         probability        expected return

great                             100%             30%                    30%

normal                            50%             40%                    20%

bad                                  0%              30%                     0%

total                                                   100%                    50%

Both stocks have the same expected return, but stock B is less risky because the chance of being a bad investment is lower.