Starting Right Corporation
After watching a movie about a young woman who quit asuccessful corporate career to start her own baby food company,Julia Day decided that she wanted to do the same. Inthe movie, the baby food company was very successful. Juliaknew, however, that it is much easier to make a movie abouta successful woman starting her own company than to actuallydo it. The product had to be of the highest quality, andJulia had to get the best people involved to launch the newcompany. Julia resigned from her job and launched her newcompany—Starting Right.Julia decided to target the upper end of the baby food marketby producing baby food that contained no preservatives buthad a great taste. Although the price would be slightly higherthan for existing baby food, Julia believed that parents would bewilling to pay more for a high-quality baby food. Instead of puttingbaby food in jars, which would require preservatives to stabilizethe food, Julia decided to try a new approach. The babyfood would be frozen. This would allow for natural ingredients,no preservatives, and outstanding nutrition.Getting good people to work for the new company wasalso important. Julia decided to find people with experiencein finance, marketing, and production to get involved withStarting Right. With her enthusiasm and charisma, Julia wasable to find such a group. Their first step was to developprototypes of the new frozen baby food and to perform asmall pilot test of the new product. The pilot test receivedrave reviews.The final key to getting the young company off to a goodstart was to raise funds. Three options were considered: corporatebonds, preferred stock, and common stock. Julia decidedthat each investment should be in blocks of $30,000. Furthermore,each investor should have an annual income of at least$40,000 and a net worth of $100,000 to be eligible to invest inStarting Right. Corporate bonds would return 13% per year forinformation is not favorable, the probability of a successfulstore is only 0.2. Without any information,Sue estimates that the probability of a successfulstore will be 0.6. A successful store will give a returnof $100,000. If the store is built but is not successful,Sue will see a loss of $80,000. Of course,she could always decide not to build the retail store.(a) What do you recommend?(b) What impact would a 0.7 probability of obtainingfavorable information have on Sue’s decision?The probability of obtaining unfavorableinformation would be 0.3.(c) Sue believes that the probabilities of a successfuland an unsuccessful retail store given favorableinformation might be 0.8 and 0.2, respectively,instead of 0.9 and 0.1, respectively. What impact,if any, would this have on Sue’s decision and thebest EMV?(d) Sue had to pay $20,000 to get information. Wouldher decision change if the cost of the informationincreased to $30,000?(e) Using the data in this problem and the followingutility table, compute the expected utility. Is thisthe curve of a risk seeker or a risk avoider?MONETARYVALUE UTILITY$100,000 1$80,000 0.4$0 0.2–$20,000 0.1–$80,000 0.05–$100,000 0˚(f) Compute the expected utility given the followingutility table. Does this utility table represent arisk seeker or a risk avoider?MONETARYVALUE UTILITY$100,000 1$80,000 0.9$0 0.8–$20,000 0.6–$80,000 0.4–$100,000 0CASE STUDY 111the next five years. Julia furthermore guaranteed that investorsin the corporate bonds would get at least $20,000 back at theend of five years. Investors in preferred stock should see theirinitial investment increase by a factor of 4 with a good marketor see the investment worth only half of the initial investmentwith an unfavorable market. The common stock had the greatestpotential. The initial investment was expected to increase bya factor of 8 with a good market, but investors would lose everythingif the market was unfavorable. During the next five years,it was expected that inflation would increase by a factor of 4.5%each year.
1. Sue Pansky, a retired elementary school teacher, is consideringinvesting in Starting Right. She is very conservativeand is a risk avoider. What do you recommend?
2. Ray Cahn, who is currently a commodities broker, is alsoconsidering an investment, although he believes that there isonly an 11% chance of success. What do you recommend?
3. Lila Battle has decided to invest in Starting Right. Whileshe believes that Julia has a good chance of being successful,Lila is a risk avoider and very conservative. Whatis your advice to Lila?
4. George Yates believes that there is an equally likelychance for success. What is your recommendation?
5. Peter Metarko is extremely optimistic about the marketfor the new baby food. What is your advice for Pete?
6. Julia Day has been told that developing the legal documentsfor each fundraising alternative is expensive. Juliawould like to offer alternatives for both risk-averse andrisk-seeking investors. Can Julia delete one of the financialalternatives and still offer investment choices for riskseekers and risk avoiders?