Word Problem

Question

You are considering investing in your brother-in-law's start-up venture. To buy a stake in his company, you must contribute $10,000. Based on your knowledge of the company (and your brother-in-law) you estimate the following possible outcomes for your investment in one year's time:

30% chance the company will go under and you will not be able to retrieve any amount of your investment
40% chance your investment will be worth half ($5000)
25% chance the company will break even and your investment will be worth the same
5% chance the company will be a runaway success and your investment will be worth $200,000
Assuming no inflation or discounting the time value of money, what is the expected value of a decision to invest $10,000 in your brother-in-law's company (including your initial investment)?

Answer 1

The expected value of the decision is the sum of the consequence of that outcome times the probability of the outcome.

 

outcome     probability   outcome times probability  

0                .3                        0

5000           .4                       2000

10000          .25                    2500

2000000       .05                  10000

 

Total             100%             14500

 

Initial cost  = 10000

 

The expected value is 14500 - 10000 or 4500