Answer to Question #233754 in Economics for Frank

Question

You are trying to decide whether to buy stock in Company X or Company Y. Both companies need $1,000 capital investment and will earn $200 in good years (with probability 0.5) and $60 in bad years. The only difference between the companies is that Company X is planning to raise all of the $1,000 needed by issuing equity, while Company Y plans to finance $500 through equity and $500 through bonds on which 10 percent interest must be paid. Construct a table showing the expected value and standard deviation of the equity return for each of the companies. Based on this table, in which company would you buy stock? Explain your choice.

Answer 1

X GY BY

1000 200 60

Y

500 195 55

I would choose company Y, since the initial investment there is two lower, and the profitability is not much lower.