CHAPTER 12: DECISION-MAKING UNDER RISK AND UNCERTAINTY

&EARNING O'(ECTI)ES
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Overview of Freem r! A""e# $i%er# Freemark Abbey was a winery located in Californias Napa Valley. It produced only premium wines. One of the partners that owned Freemark, illiam !ae"er, was

confronted with an important decision. #ecent weather reports su""ested that a storm mi"ht hit the Napa Valley. If the storm hit the $alley, the rainwater could concei$ably swell the berries and reduce their concentration. If so, the sellin" price of the wine would decrease by %.&'(bottle. )he possibility also e*isted, howe$er, that the storm would cause the botrytis mold to form on the "rape skins. If the mold formed, the wine would be hi"hly $alued by connoisseurs and could be sold at more than double the normal price. )he hi"her price, howe$er, would be partially offset by a decrease in the +uantity sold.

)he alternati$e would be to har$est the "rapes in ad$ance of the storm. If the "rapes were har$ested immediately, the wine could be sold at a price of %-.&'(bottle. In makin" his decision, !ae"er also had to determine the ramifications if he waited for the storm and it did not hit the re"ion. .ltimately, the price depended on the su"ar concentration. In "eneral, the hi"her the percenta"e of su"ar concentration, the hi"her the price. In determinin" whether to har$est the "rapes or wait for the storm, !ae"er had to estimate the likelihood the storm would hit, the odds that the mold would form if the storm hit, and the probabilities of $arious su"ar concentration le$els if the storm did not hit the re"ion. Re2ev %* Reve%0e;Co,* A% 2#,i, %1 U%-er* i%*# /our firm is tryin" to decide where to locate its new retail outlet. /ou determine that if you locate the outlet on the west side of town, it will "enerate operatin" profits of %' million(year. If you position the outlet on the east side of town, it will produce an annual profit of %& million. here should you build the outlet0

If only decisions were this easy. In the real world, a firms annual operatin" profits are uncertain. hat if other firms locate an outlet near yours0 hat if they hat if

launch an a""ressi$e marketin"(pricin" strate"y0 the minimum wa"e increases0

hat if property ta*es rise0

.ntil now, we$e implemented rele$ant re$enue(rele$ant cost analysis under the assumption that both the cost and re$enue fi"ures were known. In fact, that will rarely be the case. In the real world, a firms re$enues and costs depend on a $ariety of factors. )hese factors are often referred to as ,* *e, of % *0re because they are beyond the control of the firm. If the firm could control these factors, it would manipulate them to

its benefit. Instead, the states of nature represent constraints the company must deal with. As the states of nature $ary, the le$el of uncertainty associated with a strate"ic decision increases, and uncertainty breeds risk. 1ence, in this chapter, we mo$e from discussin" rele$ant re$enues and costs to rele$ant expected re$enues and costs. .nfortunately, as the number of factors mount, the number of potential outcomes increases, sometimes e*ponentially. )his can make it increasin"ly difficult for the firm to di"est the information in such a way as to make an ob2ecti$e, accurate decision. In this chapter, we will discuss the tools to allow a firm lay out its potential outcomes and to utili3e simple summary statistics that make it relati$ely easy for firms to compare alternati$es and make decisions. De-i,io% Tree, )o help lay out the $arious outcomes associated with the firms initiati$e, we can piece to"ether a 1e-i,io% *ree. )he purpose of a decision tree is to create a roadmap of sorts that lays out the $arious cost and re$enue fi"ures associated with a "i$en decision. )he decision tree includes an assortment of branches, each one dictated by the states of nature. 4ome will affect the firms re$enues, whereas others affect the firms costs. At the end of each branch is an outcome and the probability the outcome is likely to occur. )he first fork in the decision tree refers to the decision the mana"er wishes to make. In the Freemark Abbey inery case, illiam !ae"er needed to decide whether to

har$est the "rapes immediately or lea$e them on the $ine and await a possible storm. If he decides not to har$est the "rapes, his re$enues depend on whether the storm hits. If the storm hits, his re$enues will depend on whether the mold forms. If the storm does not hit, the sellin" price of a bottle of wine will depend on the le$el of su"ar concentration.

)he decision tree allows the decision6maker to lay out the potential outcomes and the probabilities that each outcome will occur. 7ets create our own e*ample to illustrate a decision tree. 4uppose a firm is tryin" to determine whether to e*pand into the 8etroit market or the )win Cities 9:inneapolis(4t. ;aul<. =ecause the firm presumably will locate at the most profitable location, the mana"er should compile a list of the states of nature that could affect the re$enues and costs at each location. )he mana"er can use basic economic theory to compile a list of states of nature. On the demand side, the +uantity demanded depends on the price, consumer tastes and preferences, the price of complementary "oods, the price of substitute "oods, consumer incomes, price e*pectations, and the number of potential buyers. Althou"h the firm has control o$er a few of these factors, such as the products price, the price the firm char"es depends on factors beyond its control, such as the price char"ed by competin" firms. On the cost side, the firms e*penses are e+ual to the some of its fi*ed and $ariable costs, which are often influenced by states of nature beyond the firms control. For e*ample, if market wa"es are risin", the firm will be forced to offer hi"her wa"es to attract and retain +ualified workers. 7ets walk throu"h a simple e*ample. )he first step in buildin" a decision tree is to create a fork in the road that identifies mana"ements alternati$es. In our e*ample, the firm wishes to determine whether to e*pand into 8etroit or :inneapolis(4t. ;aul. Ne*t, the mana"er seeks to determine the rele$ant costs associated with each location. An in$esti"ation re$eals that if the firm locates in 8etroit, it will face the followin" costs>

Fi*ed costs> %5@@,@@@ Variable costs> %,-(unit )he )win Cities location has the followin" cost structure> Fi*ed costs> %A@@,@@@ Variable costs> %,@(unit )he firm belie$es there is a -@B chance the raw materials needed for production will be in short supply. If so, the $ariable costs are e*pected to rise to %,? in 8etroit and %,5 in the )win Cities. )his is incorporated into the decision tree throu"h a pair of branchesC one branch shows the e*istin" cost structure and the other e*hibits the hi"her costs. Ne*t, the mana"er seeks to determine the rele$ant re$enues associated with each location. 1e(she determines that unit sales are sensiti$e to the state of the economy. If the economy is normal, the firm will likely sell 5'@,@@@ units per year in 8etroit and 5D',@@@ in the )win Cities. If the economy is in a recession, sales fall to -@@,@@@ units per year in 8etroit and ,&@,@@@ in the )win cities. )he economy a$era"es one recession e$ery four years. Accordin"ly, then, the decision tree illustrates the uncertainty in unit sales by creatin" a pair of branches at each location. If the firm locates in 8etroit and the economy is normal, the firm will sell 5'@,@@@ units. If the economy falls into a recession, unit sales will fall to -@@,@@@ units. On the other hand, if the firm locates in the )win Cities, it will sell 5D',@@@ units if the economy is normal and ,&@,@@@ durin" a recession. =ased on past history, the likelihood of a recession is -'B 9which, of course, implies the probability of a normal economy is D'B<. correspondin" branches. e will note the probabilities at their

'

#ele$ant re$enues are also affected by the price. )he price depends on whether one of the firms competitors tri""ers a price war. ;rice wars tend to occur once e$ery three years. ithout a price war, the firm can e*pect to char"e %-@(unit at either location.

8urin" a price war, the price is e*pected to fall to %,'(unit in 8etroit and %,5 in the )win Cities. )he market demand for the "ood is fairly inelastic. If a price war breaks out, unit sales will tend to rise by ,@B at either location. e accommodate the uncertainty in prices in the decision tree throu"h a subse+uent set of branches. In the absence of a price war, the firm e*pects to char"e %-@(unit in 8etroit. 4hould a price war occur, the price will drop to %,'. )he firm also e*pects to char"e %-@ in the )win Cities in the absence of a price war. 1owe$er, if a price war were to take place, the firms price will fall to %,5. )hese branches also incorporate the chan"e in unit sales that may arise from a price war. )he firm anticipates the likelihood of a price war to be 55BC thus, the branches post the respecti$e probabilities. EFi"ure , hereF Fi"ure , shows the decision tree. Note how the decision tree allows the mana"er to determine the $arious profit outcomes arisin" from the rele$ant re$enues and costs at each location. In this case, the branches of the tree lead to ei"ht different outcomes, each one e*hibitin" the firms profits under $arious scenarios. Assumin" the states of nature are independent of each other, the probability of any three states of nature occurrin" simultaneously is the product of the indi$idual probabilities. For e*ample, if the probability of a lower cost structure is @.&@, the probability of a normal economy is @.D' and the probability of a price war is @.55, then the probability of all three occurrin"

simultaneously is @.&@ * @.D' * @.55 G .?@-@. probabilities for each plant as shown in )able ,.

e can now combine the outcomes and

T "2e 1 De*roi* S-e% rio 7ow Cost( Normal Hconomy( No ;rice ar 7ow Cost( #ecession( No ;rice ar 7ow Cost( Normal Hconomy( ;rice ar 7ow Cost( #ecession( ;rice ar 1i"h Cost( Normal Hconomy( No ;rice ar 1i"h Cost( #ecession( No ;rice ar 1i"h Cost( Normal Hconomy( ;rice ar 1i"h Cost( #ecession( ;rice ar O0*-ome Pro" "i2i*# Twi% Ci*ie, O0*-ome Pro" "i2i*#

%-,'@@,@@@

.?@-@

%5,,'@,@@@

.?@-@

%,,5@@,@@@

.,5?@

%,,-@@,@@@

.,5?@

%&'',@@@

.,I&@

%A5D,'@@

.,I&@

%5A@,@@@

.@AA@

9%A,@@@<

.@AA@

%,,&@@,@@@

.,@@'

%-,@-',@@@

.,@@'

%I@@,@@@

.@55'

%AA@,@@@

.@55'

%&',@@@

.@?I'

9%A@@,@@@<

.@?I'

9%&@,@@@<

.@,A'

9%A@@,@@@<

.@,A'

Althou"h the decision tree lists the $arious outcomes at each location and their correspondin" probabilities, the mana"er is left to di"est the information. In the ne*t

section of this chapter, we will discuss se$eral summary statistics that pro$ide concise, yet accurate information from which an ob2ecti$e decision can be made.

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

)he decision tree is a tool mana"ers can use to anticipate the $arious cash flows that mi"ht occur if a "i$en decision is implemented. Hach branch of a decision tree details an e*ternal factor 9a.k.a. state of nature< that could affect the firms price, output, and(or cost structure.

E4.e-*e1 ) 20e 7ets i"nore the probabilities for the time bein". )he outcomes associated with each location are shown in )able -.

&

T "2e 2 De*roi* S-e% rio 7ow Cost( Normal Hconomy( No ;rice ar 7ow Cost( #ecession( No ;rice ar 7ow Cost( Normal Hconomy( ;rice ar 7ow Cost( #ecession( ;rice ar 1i"h Cost( Normal Hconomy( No ;rice ar 1i"h Cost( #ecession( No ;rice ar 1i"h Cost( Normal Hconomy( ;rice ar 1i"h Cost( #ecession( ;rice ar O0*-ome Twi% Ci*ie, O0*-ome

%-,'@@,@@@

%5,,'@,@@@

%,,5@@,@@@

%,,-@@,@@@

%&'',@@@

%A5D,'@@

%5A@,@@@

9%A,@@@<

%,,&@@,@@@

%-,@-',@@@

%I@@,@@@

%AA@,@@@

%&',@@@

9%A@@,@@@<

9%&@,@@@<

9%A@@,@@@<

hich location is the most profitable0 )he easiest way to compare alternati$es is to calculate the a$era"e cash flow at each location. As you know, the mean is calculated as>

x=

x
i =,

In this case, the a$era"e annual cash flow in 8etroit is %IA',@@@(year as compared to %&@&,5,-.'@(year in the )win Cities. =efore choosin" 8etroit, we need to be careful. hen one calculates the mean,

he(she implicitly assumes each outcome is e+ually likely. In realistic business scenarios, this is hi"hly unlikely. 4ome outcomes are almost always more likely to occur than others. If so, then a strai"ht comparison of mean outcomes may be biased and could mislead the decision6maker. hen the probabilities of $arious outcomes differ 9as they do in )able ,<, the appropriate way to determine the a$era"e is to calculate the e4.e-*e1 v 20e. )he e*pected $alue 9J< is a wei"hted a$era"e. It wei"hts each outcome by the probability it will occur. )he e*pected $alue is calculated as>
n

= Pi X i ,
i =,

where ;i is the probability e$ent i will occur and Ki is the outcome of e$ent i. 7ets calculate the e*pected $alue for each location. =ased on the fi"ures in )able ,, if we locate in 8etroit, our e*pected annual cash flow is> 9%-,'@@,@@@ * .?@-@< L 9%,,5@@,@@@ * .,5?@< L 9%&'',@@@ * .,I&@< L 9%5A@,@@@ * .@AA@< L 9%,,&@@,@@@ * .,@@'< L 9%I@@,@@@ * .@55'< L 9%&',@@@ * .@?I'< M 9%&@,@@@ * .@,A'< G %,,'&A,,&D.'@.

,@

)he e*pected annual cash flow at the )win Cities location is> 9%5,,'@,@@@ * .?@-@< L 9%,,-@@,@@@ * .,5?@< L 9%A5D,'@@ * .,I&@< 6 9%A,@@@ * .@AA@< L 9%-,@-',@@@ * .,@@'< L 9%AA@,@@@ * .@55'< 6 9%A@@,@@@ * .@?I'< M 9%A@@,@@@ * .@,A'< G %,,D5&,I',.'@. Note how incorporatin" the likelihood each e$ent will occur alters the fi"ures. Calculatin" the a$era"e annual outcome in 8etroit usin" a strai"ht mean was %IA',@@@. =y buildin" in the probabilities of each outcome, the fi"ure rises to %,,'&A,,&D.'@. 4imilarly, the a$era"e annual profit at the )win Cities without incorporatin" probabilities was %&@&,5,-.'@. )he wei"hted a$era"e, on the other hand, was %,,D5&,I',.'@. )he lar"e difference between the strai"ht mean and the e*pected $alue stems from the fact that the more positi$e scenarios are si"nificantly more likely to occur than the least fa$orable scenarios. For e*ample, the probability of a low cost structure combined with a normal economy and no price war is ?@.-B. In contrast, the likelihood of a hi"h cost structure combined with a recession and a price war is only ,.A'B. )he strai"ht a$era"e attached e+ual wei"ht to each of these outcomes, resultin" in a mean that was biased downward.

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

,. hen the likelihood of $arious outcomes differs, the mana"er can determine the mean outcome by calculatin" the e*pected $alue. -. )he e*pected $alue 9J< is a wei"hted a$era"e. It is calculated by multiplyin" each outcome by its correspondin" probability and then summin" them up across all outcomes, or> = Pi X i
i =, n

,,

S* %1 r1 Devi *io% 7ets alter the cash flows for the )win Cities. )he cash flows at the two locations and their respecti$e probabilities are shown in )able 5. T "2e 5 De*roi* S-e% rio 7ow Cost( Normal Hconomy( No ;rice ar 7ow Cost( #ecession( No ;rice ar 7ow Cost( Normal Hconomy( ;rice ar 7ow Cost( #ecession( ;rice ar 1i"h Cost( Normal Hconomy( No ;rice ar 1i"h Cost( #ecession( No ;rice ar 1i"h Cost( Normal Hconomy( ;rice ar 1i"h Cost( #ecession( ;rice ar O0*-ome Pro" "i2i*# Twi% Ci*ie, O0*-ome Pro" "i2i*#

%-,'@@,@@@

.?@-@

%5,@@@,@@@

.?@-@

%,,5@@,@@@

.,5?@

%,,,@@,@@@

.,5?@

%&'',@@@

.,I&@

%'A,,@@@

.,I&@

%5A@,@@@

.@AA@

9%',,D'@<

.@AA@

%,,&@@,@@@

.,@@'

%,,A'@,@@@

.,@@'

%I@@,@@@

.@55'

%?A-,'@@

.@55'

%&',@@@

.@?I'

9%&I@,-'@<

.@?I'

9%&@,@@@<

.@,A'

9%D5?,I5,.'@< .@,A'

,-

)he fi"ures for 8etroit are the sameC hence, the e*pected $alue at 8etroit is still %,,'&A,,&D.'@. For the )win Cities, howe$er, the e*pected $alue is> 9%5,@@@,@@@ * .?@-@< L 9%,,,@@,@@@ * .,5?@< L 9%'A,,@@@ * .,I&@< M 9%',,D'@ * .@AA@< L 9%,,A'@,@@@ * .,@@'< L 9%?A-,'@@ * .@55'< M 9%&I@,-'@ * .@55'< M 9%D5?,I5,.'@ * .@,A'< G %,,'&A,,&D.'@. Accordin" to the e*pected $alue fi"ures, the a$era"e annual cash flows are the same at each location. O$er time, therefore, the locations should be e+ually profitable. )his be"s the +uestion> based on the numbers in )able 5, do you ha$e a preference0 4ome students may prefer 8etroit. If the firm locates at 8etroit, the worst case scenario is a ne"ati$e cash flow of %&@,@@@ as compared with a potential loss of %&I@,-'@ at the )win Cities location. Other students may prefer the )win Cities, based on the fact that cash flows could potentially reach %5,@@@,@@@ as compared with a best case scenario of only %-,'@@,@@@ 8etroit. In "eneral, students who prefer 8etroit notice that the outcomes are fairly close to"ether whereas the outcomes at the )win Cities are more dispersed. hen the

outcomes are fairly close to"ether, the decision6maker is willin" to fore"o the potential for hi"hly desirable outcomes to a$oid the less desirable outcomes. )hese indi$iduals ha$e ri,! ver,e preferences. )hose who prefer the )win Cities ha$e ri,!-,ee!i%< preferences. )hey are willin" to risk less fa$orable outcomes to ha$e a shot at the most desirable result. Of course, other students may decide the location doesnt matter because the a$era"e e*pected cash flow is the same in each re"ion. 4uch persons are e*hibitin" ri,! %e0*r 2 preferences.

,5

.ltimately, those with risk a$erse or risk6seekin" preferences are usin" the ,* %1 r1 1evi *io% of the outcomes to help them make a decision. As you may recall from your basic statistics class, standard de$iation 9N< is a measure of the indi$idual outcomes around the mean. )he basic calculation of standard de$iation is>

9Xi X <
i =,

n ,

where Ki is the $alue of obser$ation i and X is the mean outcome. 1owe$er, as with the calculation of the mean, the basic calculation of standard de$iation implies each obser$ation is e+ually likely to occur. )o ad2ust for differin" probabilities, we multiply each s+uared difference by its correspondin" probability instead of summin" the s+uared differences and di$idin" by n-1. )he proper calculation of standard de$iation when the outcomes are not e+ually likely to occur is, therefore>

P 9X
i =, i

< -

where ;i is the probability outcome i will occur. Notice also that the e*pected $alue 9J< replaces the mean X from the standard calculation. Fi"ure - shows the distribution of two sets of outcomes. Assumin" some students ha$e encountered a dense buildup of brain cobwebs from the time they first took their basic statistics class, lets re$iew the concept of the normal cur$e. )he outcomes appear on the hori3ontal a*is and the fre+uency of the outcomes 9i.e. the number of times the outcome occurred<. )he taller the cur$e, the more fre+uently the outcome occurred. Notice that the fre+uency is "reatest at the e*pected $alue. As we mo$e farther away from the e*pected $alue in either direction, the number of times the outcome occurred

,?

decreases. )he bell6shaped %orm 2 1i,*ri"0*io% assumes the distribution of outcomes is symmetric around the mean. EFi"ure - hereF In interpretin" the concept of standard de$iation $isually, note that in distribution 9a<, the outcomes are relati$ely close to the mean. =ecause the ran"e of potential outcomes is relati$ely small, the standard de$iation is relati$ely small. )his implies less uncertainty re"ardin" the outcomes and, therefore, less risk. In contrast, the outcomes on distribution 9b< are more spread out. As a result, the standard de$iation will be hi"her, implyin" more uncertainty and risk. 7ets calculate the standard de$iation of the cash flow fi"ures for the 8etroit and )win Cities locations. For 8etroit, the standard de$iation is> O9%-,'@@,@@@ 6 %,,'&A,,&D.'@<- * .?@-@ L 9%,,5@@,@@@ 6 %,,'&A,,&D.'@<- * .,5?@ L 9%&'',@@@ 6%,,'&A,,&D.'@<- * .,I&@ L 9%5A@,@@@ 6 %,,'&A,,&D.'@<- * .@AA@ L 9%,,&@@,@@@ 6 %,,'&A,,&D.'@<- * .,@@' L 9%I@@,@@@ 6 %,,'&A,,&D.'@<- * .@55' L 9%&',@@@ 6 %,,'&A,,&D.'@<- * .@?I' M 9%&@,@@@ 6 %,,'&A,,&D.'@<- * .@,A' G %&'?,@I&. )he standard de$iation for the )win Cities is> O9%5,@@@,@@@ 6 %,,'&A,,&D.'@<- * .?@-@ L 9%,,,@@,@@@ 6 %,,'&A,,&D.'@<- * .,5?@ L 9%'A,,@@@ 6%,,'&A,,&D.'@<- * .,I&@ 6 9%',,D'@ 6 %,,'&A,,&D.'@<- * .@AA@ L 9%,,A'@,@@@ 6 %,,'&A,,&D.'@<- * .,@@' L 9%?A-,'@@ 6 %,,'&A,,&D.'@<- * .@55' 6 9%&I@,-'@ 6 %,,'&A,,&D.'@<- * .@?I' M 9%D5?,I5- 6 %,,'&A,,&D.'@<- * .@,A' G %,,-&A,A&A.

,'

hat do these numbers mean0 If you e*amine the e+uation, youll see that the standard de$iation is the s+uare root of the a$era"e s+uared de$iation between each outcome and the mean outcome. If that e*planation lea$es your head spinnin", lets simply note that your first operation in calculatin" standard de$iation is to take the difference between each outcome and the mean outcome. )hese differences are then s+uared to assure they do not cancel each other out when summed. )hus, the more spread out the outcomes, the lar"er the difference between each outcome and the mean. Conse+uently, the more dispersed the outcomes, the lar"er the standard de$iation. =ecause the standard de$iation for the )win Cities is hi"her than for 8etroit, we know the ran"e of outcomes for the )win Cities is "reater. 4tatisticians apply C+e"#,+ev=, T+eorem to make inferences from standard de$iation. Chebyshe$ pro$ed the proportion of any data set lyin" within k standard de$iations of the mean is at least , M ,(k-, where k is any positi$e number "reater than ,. For e*ample, we can infer that at least 9, M P-<, or D'B of the outcomes will lie within two standard de$iations of the mean. hen the distribution of outcomes is normally distributed, we can make better inferences than Chebyshe$s )heorem permits. 4ometimes called the G 0,,i % 1i,*ri"0*io% 9named after Qerman mathematician Friedrich Qauss<, we can infer the followin" empirical rules which will become e*tremely useful when we "et to the chapter on re"ression analysis. In "eneral, when the number of obser$ations is $ery lar"e> 9a< I@B of the obser$ations lie within ,.A?' standard de$iations of the mean 9b< I'B of the obser$ations lie within ,.IA standard de$iations of the meanC and 9c< IIB of the obser$ations lie within -.'& standard de$iations of the mean.

,A

Assumin" the distribution of cash flows are normally distributed, we can infer that I@B of the time, the annual cash flows in 8etroit will ran"e between %,&,,,IA and %-,II,,,DI. At the riskier )win Cities location, annual cash flows will ran"e between 6 %'5@,?,, and %5,D@-,D&A I@B of the time. Clearly, couplin" e*pected $alue with standard de$iation allows the decision6maker to assess not only the a$era"e outcome but also the le$el of risk associated with the alternati$es.

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

,. )he le$el of risk associated with a decision can be inferred from the standard de$iation 9N<. )he standard de$iation is a measure of the dispersion of outcomes around the mean. It is calculated as>
=

P 9X
i =, i

< -

-. )he lar"er the standard de$iation, the more dispersed the outcomes. )herefore, in "eneral, the hi"her the standard de$iation, the "reater the risk associated with the decision. 5. If the number of obser$ations is relati$ely lar"e, mana"ers can use the Qaussian distribution to infer the followin"> a. I@B of the obser$ations lie within ,.A?' standard de$iations of the mean b. I'B of the obser$ations lie within ,.IA standard de$iations of the meanC and c. IIB of the obser$ations lie within -.'& standard de$iations of the mean.

,D

Coeffi-ie%* of ) ri *io% Althou"h standard de$iation is a "ood tool to assess risk, it can be misleadin". )o illustrate, lets take a look at the followin" alternati$es. A firm is considerin" launchin" one of two initiati$es. )he outcomes associated with each initiati$e, alon" with the correspondin" probabilities, appear in )able ?. )he e*pected $alue for Alternati$es A and = are %D@ and %,,@@@,@?@, respecti$ely. T "2e 6 A2*er% *ive A C ,+ F2ow %@ 6%,@@ %5'@ %'@ %@ Pro" "i2i*# .,@ .,@ .-@ .-@ .?@ A2*er% *ive ' C ,+ F2ow %,,@@@,,@@ %III,&@@ %,,@@@,'@@ %III,I'@ %III,I@@ Pro" "i2i*# .,@ .,@ .-@ .-@ .?@

hich alternati$e is riskier0 )he standard de$iation for Alternati$e A is> O9%@ 6 %D@<- * .,@ L 96%,@@ 6 %D@<- * .,@ L 9%5'@ 6 %D@<- * .-@ L 9%'@ 6 %D@<- * .-@ L 9%@ 6 %D@<- * .?@ G %,?' )he standard de$iation for Alternati$e = is> O9%,,@@@,,@@6 %,,@@@,@?@<- * .,@ L 9%III,&@@ 6 %,,@@@,@?@<- * .,@ L 9%,,@@@,'@@ 6 %,,@@@,@?@<- * .-@ L 9%III,I'@ 6 %,,@@@,@?@<- * .-@ L 9%III,I@@ 6 %,,@@@,@?@<- * .?@ G %-?@.

,&

At first "lance, = appears to be the riskier of the two because the standard de$iation is nearly twice as lar"e for = as it is for A. =ut lets employ the empirical rule of thumb used earlier. If A is initiated, I@B of the cash flows will lie between 6%,A& and %5@I. If = is implemented, I@B of the cash flows will lie between %III,A?' and %,,@@@,?5'. 4o which alternati$e is riskier0 In comparin" Alternati$es A and =, we need to distin"uish between ",o20*e ri,! and re2 *ive ri,!. 4tandard de$iation allows one to infer absolute risk. On an absolute dollar le$el, = does imply a "reater spread amon" likely outcomesC after all, %,,@@@,?5' 6 %III,A?' G %DI@, which is "reater than %5@I M 9%,A&< G %?DD. 1owe$er, on a relati$e basis, when one considers the e*pected $alue for each alternati$e 9%D@ for A and %,,@@@,@?@ for =<, a swin" between 6%,A& and %5@I is a lot lar"er than the %DI@ difference between %,,@@@,?5' and %III,A?'. On a relati$e basis, Alternati$e = is practically a certain outcome. Althou"h absolute risk is hardly a worthless concept, usin" standard de$iation to assess risk when the difference between the e*pected $alues of two or more alternati$es is fairly lar"e is inherently an apples6and6oran"es comparison. =ecause relati$e risk is fre+uently more important to the decision6maker, we calculate the -oeffi-ie%* of v ri *io% 9R< to allow for an apples6to6apples comparison of risk. Calculatin" the coefficient of $ariation is fairly intuiti$e. e inferred that = was

less risky than A because its standard de$iation was small relati$e to its e*pected $alue. Not surprisin"ly, then, the coefficient of $ariation is simply the standard de$iation di$ided by the e*pected $alue, or N(J. )he correspondin" coefficients of $ariation for A and = are>

,I

A> %,?'(%D@ G %-.@DC and => %-?@(%,,@@@,@?@ G %@.@@@-? =y di$idin" the standard de$iations by the e*pected $alue, we are measurin" the dispersion of outcomes per e*pected dollar in cash flow. For each e*pected dollar in As cash flow, there is %-.@D in dispersion amon" outcomes. For each e*pected dollar in =s cash flow, there is %@.@@@-? in dispersion amon" outcomes. Note how its easier to compare the le$els of risk in A and = by measurin" the dispersion per expected dollar.

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

,. 4tandard de$iation measures the absolute risk associated with a decision. -. hen comparin" alternati$es, mana"ers may wish to e*amine relati$e risk. )his can be done by calculatin" the coefficient of $ariation 9R<, which is the standard de$iation di$ided by the e*pected $alue, or R G N(J. 5. )he coefficient of $ariation determines the dispersion of outcomes per unit of e*pected $alue. For e*ample, if e*pected $alue measures the e*pected profit in dollars, the coefficient of $ariation measures the dispersion of outcomes per dollar of e*pected profit. )his allows the relati$e risk from differin" alternati$es to be easily compared.
7ets return to our ori"inal 8etroit()win Cities e*ample 9)able ,<. )he summary statistics for each location are>

-@

De*roi*: H*pected Value> %,,'&A,,&D.'@ 4tandard 8e$iation> %&'?,@I& Coefficient of Variation> %.'? Twi% Ci*ie,: H*pected Value> %,,D5&,I',.'@ 4tandard 8e$iation> %,,-II,'5? Coefficient of Variation> %.D' As the analysis indicates, the e*pected profit in the )win Cities 9%,,D5&,I',.'@< e*ceeds that of 8etroit 9%,,'&A,,&D.'@<. 1owe$er, the )win Cities market is more risky than the 8etroit market, as e$idenced by the coefficient of $ariation 9%.D' per e*pected dollar in the )win Cities as opposed to %.'? per e*pected dollar in 8etroit<. Althou"h accountants can readily piece to"ether the profits associated with each outcome, where do the probabilities come from0 .nfortunately, in business situations, determinin" the probability of a normal economy coupled with a price war is not the same as flippin" a coin an infinite number of times and pro2ectin" the percenta"e of times the coin flip comes up heads. Althou"h the probabilities in decision tree analysis may reflect historical odds, they are inherently sub2ecti$e 9e$en historical odds may not predict future odds<. Is it possible a mana"ers decision may be swayed by assessin" probabilities incorrectly0 Indeed, thats a possibility. 1owe$er, throu"h sensiti$ity analysis, the mana"er can toy with the numbers to determine the impact of different probabilities on e*pected $alue. 7ets return to the 8etroit()win Cities e*ample to illustrate. Qi$en the

-,

assumed probabilities of a hi"her cost structure, a normal economy and a price war, we determined the e*pected $alues of the 8etroit and )win Cities markets to be %,,'&A,,&D.'@ and %,,D5&,I',.'@, respecti$ely. 1ow would chan"in" the probabilities affect the summary statistics0 Is it possible that a different set of probabilities could cause the mana"er to chan"e his(her decision0 e can e*amine the probability associated with each state of nature. For e*ample, if we assume a low cost structure, the e*pected $alues for 8etroit and the )win Cities are %,,D,',5,5, and %,,I?,,,A, respecti$ely. If we assume a hi"h cost structure, the e*pected $alues are %,,@AI,A&& and %I5@,,,-.'@, respecti$ely. Assume the probability of a lower cost structure 9;< is unknown. If so, the e*pected profit in 8etroit and the )win Cities would be> 8etroit> %,,D,',5,5; L %,,@AI,A&&9, M ;<, andC )win Cities> %,,I?,,,A,; L %I5@,,,-.'@9, M ;<, where ; is the probability of a lower cost structure. )o determine the probability of a lower cost structure that would yield identical e*pected $alues for the two locations, we set the e*pected $alues e+ual to each other and sol$e for ;, or> %,,D,',5,5; L %,,@AI,A&&9, M ;< G %,,I?,,,A,; L %I5@,,,-.'@9, M ;<, or ; G 5&.-B. )his pro$ides useful information to the decision6maker. )he 8etroit location yields a hi"her e*pected $alue than the )win Cities only if a hi"h cost structure e*ists. If we hold the assumptions re"ardin" the state of the economy and the price war constant, we determined that 8etroit would yield the hi"her e*pected $alue only if the probability of a low cost structure was less than 5&.-B. =ecause we ori"inally assumed the probability of

--

a low cost structure was &@B, this stren"thens our conclusion the possibility of future cost increases are unlikely to sway our location decision. e could do the same with the other two states of nature. In each case, we hold the assumptions for the other states of nature constant, and then sol$e for the probability of the remainin" state of nature. For e*ample, lets hold constant the cost structure and price war assumptions. In 8etroit, the e*pected $alue if a normal economy e*ists is %,,&,-,'5@. ith a recession, the e*pected $alue is %I@D,,A@. In the )win Cities, the

e*pected $alues for a normal economy and recession are %-,@&&,?'@ and %AI@,?'A, respecti$ely. If the probability of a normal economy is ;, the two locations will ha$e the same e*pected $alue if> %,,&,-,'5@; L %I@D,,A@9, M ;< G %-,@&&,?'@; L %AI@,?'A9, M ;<, or if ; G ??B. )hus, holdin" the other assumptions constant, the 8etroit location yields the hi"her e*pected profit only if the probability of a normal economy is less than ??B. )his is well below our ori"inal pro2ection of D'B, so the mana"er can feel fairly secure about the )win Cities location. Finally, we can e*amine the impact of the price war on the e*pected $alues in the two locations. 1oldin" constant the assumptions re"ardin" the cost structures and the state of the economy, the e*pected $alue in 8etroit without a price war is %-,@D',@@@. ith a price war, the e*pected $alue in 8etroit is %'I5,D'@. In the )win Cities, the e*pected $alue without a price war is %-,?AA,D'@. If a price war occurs, the e*pected $alue is %-A,,5@@. 7abelin" the probability that a price war does not occur as ;, the two locations ha$e the same e*pected $alue if>

-5

%-,@D',@@@; L %'I5,D'@9, M ;< G %-,?AA,D'@; L %-A,,5@@9, M ;<, or ; G ?'.IB. )his indicates that, holdin" the other assumptions constant, 8etroit will e*hibit a hi"her e*pected profit than the )win Cities only if the probability of competition without a price war is less than ?'.IB. A"ain, we assumed a 55B chance of a price war in any "i$en time period, so the )win Cities choice seems more secure. T+e ) 20e of I%form *io% )his discussion se"ues into the $alue of information. Althou"h the probabilities of $arious states of nature are rarely known and must be estimated, we can sometimes use decision tree analysis to infer the $alue of information. )he $alue of information is e+ual to the e*pected $alue with the information minus the e*pected $alue without the information. It determines the ma*imum a firm should be willin" to spend to ac+uire additional information. For e*ample, suppose a firm is considerin" launchin" a new product into the tri6 state area of western ;ennsyl$ania, eastern Ohio, and northern est Vir"inia. If

launched throu"hout its retail outlets, it anticipates a '@B chance its profit contribution will total %- million(year, a -'B chance its profit contribution will be %@.' million(year, a ,@B chance that the profit contribution will total %@., million annually, a ,@B chance its product will ha$e a ne"ati$e contribution of %@.- million, and a 'B chance its "ood will lose %@.' million annually. =ased on these pro2ections, the e*pected profit contribution is %- million * .'@ L %@.' million * .-' L %@., million * .,@ L 9%@.- million< * .,@ L 9%@.' million< * .@', or %,.@I million(year. )he product mana"er anticipates the "ood will ha$e a life of fi$e years, after which it will become obsolete. =ased on a cost of capital of &B, the present $alue of the income stream is %?.5' million.

-?

One alternati$e is to conduct a test market in its retail outlets in Akron, Ohio. If the product "enerates a positi$e profit contribution in Akron, it will be launched throu"hout the re"ion. )he %- million profit contribution for the entire re"ion will be inferred if the test market yields a profit contribution of %-@@,@@@. 4imilarly, the re"ion6 wide profit contributions of %@.' million and %@., million will be pro2ected if the test market yields profit contributions of %@.@' million and %@.@, million, respecti$ely. )he product will not be launched if the profit contribution in Akron is less than %@.@, million. =y test marketin" the product, suppose the re$ised e*pected $alue for a re"ion6 wide launch is %- million * .'@ L %@.' million * .-' L %@., million * .,@ L %@ * .,', or %,.,5' million. O$er the anticipated fi$e6year life of the product, the discounted present $alue is %?.'5 million. =ecause the discounted present $alue of the e*pected profit contribution with the test market is %?.'5 million and the e*pected profit contribution without the test market study is %?.5' million, mana"ement should be willin" to spend no more than %?.'5 million 6 %?.5' million, or %,&@,@@@ on the test market study. e can also determine the $alue of information in the Freemark Abbey inery

case. !ae"er must determine whether to har$est the "rapes immediately or wait for the upcomin" storm. 1ow much money would !ae"er be willin" to pay to find out if the storm will hit the re"ion0 Ironically, the answer is nothin". If !ae"er knows with certainty that the storm will hit, the e*pected re$enues total %5?,'&?, which is more than what he would earn if he har$ested the "rapes before the storm. 9)his assumes he determined in ad$ance that he would not bottle an inferior wine if the mold did not form<. H$en if he knew with certainty the storm would not hit, his e*pected re$enues would be e+ual to %5D,-@@, which a"ain, e*ceeds his earnin"s from an immediate har$est.

-'

hat does matter to !ae"er is whether a storm is conduci$e to the formation of the botrytis mold. If he knew the storm would not likely result in the mold, he would har$est the "rapes immediately and earn %5?,-@@. If he knew the storm was conduci$e to the mold, but mi"ht not hit the re"ion, his e*pected earnin"s from waitin" for the storm would be %?,,?@@. For this reason, !ae"er would be willin" to spend up to %?,,?@@ 6 %5',&I- 9the e*pected re$enues from delayin" the har$est<, or %','@& to learn more details about the storm.

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

4ometimes a mana"er can pay to ac+uire information to assist in decision6makin". )he mana"er can determine the $alue of the information in the followin" manner> ,. First, based on the decision tree analysis, determine the e*pected $alue of the alternati$es with e*istin" information. )his is the e*pected $alue without information. -. 4econd, determine what decision would be made with better information. )his is the e*pected $alue with information. 5. )he difference between the e*pected $alues with and without information represents the ma*imum the firm should be willin" to pay to ac+uire additional information.
De-i,io% Tree, %1 C .i* 2 '01<e*i%< In the chapters on capital bud"etin" and estimatin" cash flows, we noted that lar"e6scale decisions o$er an intermediate6 or lon"6term time frame entail a "reat deal of uncertainty. )he "eneral notion that each years after6ta* cash flow can be discounted to its present $alue implicitly assumes the cash flow fi"ures are certain. In fact, as we know, economic

-A

conditions may chan"e, competitors may enter or e*it the market, e*chan"e rates may chan"e, "o$ernment re"ulations may increase costs or restrict production, etc. As these states of nature chan"e, prices, output, and unit costs may rise or fall. 8ecision tree analysis can be an in$aluable tool for estimatin" a pro2ects future cash flow. =y compilin" a list of scenarios, the mana"er can pro2ect a series of cash flows based on a $ariety of circumstances. )he e*pected $alue of each years cash flow can be discounted to its present $alue. :oreo$er, to pro$ide a sensiti$ity analysis, the e*pected cash flows can be inflated or deflated by one to two standard de$iations. One tool for de$elopin" a sensiti$ity analysis is throu"h a Mo%*e C r2o ,im02 *io%. )his is typically a$ailable throu"h simulation software packa"es or as an add6on to :icrosoft H*cel. In simulation, the mana"er selects an e*pected $alue and standard de$iation for each rele$ant $ariable> unit sales, price, a$era"e $ariable cost, etc. )he distribution of $alues can either follow a normal, trian"ular, uniform, or lo"normal distribution 9see Fi"ure 5<. )he computer then selects a random number from the distribution and calculates the N;V. Ne*t, a second set of $alues for each $ariable is selected at random and the N;V is calculated a"ain. )his process is repeated o$er and o$er a"ain, resultin" in numerous N;V calculations. )he mean N;V, standard de$iation, and coefficient of $ariation are then reported. EFi"ure 5 hereF

-D

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

?. 8ecision trees are especially useful for determinin" the cash flows associated with capital bud"etin" decisions. '. :onte Carlo simulation, a$ailable in many spreadsheet packa"es, allows the firm to simulate the impact of $arious combinations of factors on cash flows.
De-i,io% Tree, %1 Se80e%*i 2 De-i,io%, )hus far, we ha$e introduced decision trees to determine a sin"le decision by mana"ement. )he first fork in the decision tree defines the choices a$ailable to the mana"er. Hach subse+uent fork refers to factors that influence the companys profits but are beyond the firms control. Suite often, howe$er, a decision tree may re+uire the mana"er to make more than one decision. For e*ample, suppose a firm is tryin" to decide whether to launch a new product. Clearly, the decision analysis must incorporate the profits "enerated by the "ood. Of course, if the firm "oes ahead and launches the product, it will ha$e to make a pricin" decision. Naturally, the decision to launch the product hin"es on the assumption the mana"er will choose the optimal price as conditions chan"e. 1ow can the mana"er determine the e*pected $alue of an initiati$e when some of the outcomes re+uire additional decisions0 )he key to makin" se+uential decisions in decision tree analysis is to make the decisions from ri"ht to left. In other words, the mana"er needs to e*amine the last decision mandated by the tree. =y calculatin" the summary statistics, the mana"er can determine what he(she would do if the situation were to arise. From this point, the mana"er can backtrack to the ne*t decision and repeat the process. Once all subse+uent

-&

decisions ha$e been determined, the mana"er can utili3e decision analysis to e$aluate the o$erall pro2ect. e can see e*amples of the need for se+uential decision6makin" in the Freemark Abbey inery case. If a storm hits the re"ion and the mold does not form, the winery

could either sell the wine in bulk, sell the "rapes directly, or bottle and sell the wine anyway. Althou"h the latter option would "enerate twice as much re$enue in the short run, sellin" an inferior wine could dama"e the winerys reputation and inhibit future sales. 1ence, in piecin" to"ether the decision tree, !ae"er needs to determine at the front end what he would do if a storm hit the re"ion but the mold did not form. 7ets work throu"h our own e*ample to illustrate how se+uential decisions are made. 4uppose a mo$ie studio is tryin" to decide whether to finance a %,'@ million bi"6 bud"et film or two smaller films costin" %D@ million each. Suite often, the director re+uests additional fundin" to make chan"es and(or additions to the film. 4ometimes the additional funds impro$e the bo* office appeal of the mo$ie and increase the films "ross. On other occasions, the mo$ie does +uite well if the director is held to the ori"inal bud"et. )he studio e*ecuti$es anticipate a re+uest for an additional %'@ million for the bi"6bud"et film and a combined %-' million for the two smaller films. If the additional funds for the bi"6bud"et film are appro$ed, the studio e*ecs e*pect an &@B chance it will "ross %5@@ million, a ,@B chance it will "ross %-@@ million, and a ,@B chance it will "ross %&@ million. If the bud"et increase is not appro$ed, the probabilities of a %5@@ million "ross fall to A@B, with the likelihood of a %-@@ million risin" to -'B and the probability of an %&@ million "ross increasin" to ,'B.

-I

If the two smaller films are financed and bud"et increases of a combined %-' million are appro$ed, the e*ecuti$es belie$e there is a A@B chance the films will collecti$ely "ross %5@@ million. )his probability falls to 5@B if the bud"et increases are not appro$ed. 4imilarly, the likelihood the smaller films will "ross a combined %-@@ million is e*pected to be 5@B if the bud"et increase is appro$ed and ?@B if it is not appro$ed. Finally, if the additional funds are appro$ed, the likelihood the films will "ross %&@ million is ,@B and 5@B if not appro$ed. hat makes this case different from the others discussed so far is that the studio e*ecuti$es cannot decide whether to fund the bi"6bud"et film or the two smaller films without first anticipatin" the effect of the ine$itable re+uest for a bud"et increase. Fi"ure ? sets this up as a decision tree to illustrate the studio e*ecuti$es dilemma. EFi"ure ? hereF )his is the essence of decision trees with se+uential decisions> to answer the broad +uestion of whether to finance the bi"6bud"et film or the two smaller films, the studio e*ecuti$es must decide whether they would appro$e the re+uest for additional fundin". )he decision6maker must ultimately make decisions by sol$in" the decision tree from ri"ht to left. In this case, the studio e*ecuti$es must first determine whether they would appro$e a bud"et increase before they e*amine the lar"er issue of which mo$ie9s< to finance. 7ets work with the bi"6bud"et mo$ie first. If the director re+uests an additional %'@ million, the e*pected "ross is %5@@ million * .&@ L %-@@ million * .,@ L %&@ million * .,@ 6 %'@ million, or %-,& million if the bud"et increase is appro$ed, and %5@@ million * .A@ L %-@@ million * .-' L %&@ million * .,', or %-?- million if it is not appro$ed.

5@

1ence, if the studio e*ecuti$es based their decision e*clusi$ely on e*pected $alue, they would not appro$e the additional %'@ million bud"et increase. If the smaller films are financed and the directors re+uest an additional %-' million in combined bud"ets, the e*pected combined "ross is %5@@ million * .A@ L %-@@ million * .5@ L %&@ million * .,@ 6 %-' million, or %--5 million if the increase is appro$ed, and %5@@ million * .5@ L %-@@ million * .?@ L %&@ million * .5@, or %,I? million if the additional financin" is not appro$ed. )herefore, should the studio finance the smaller films, the studio e*ecuti$es would appro$e the bud"et increase. Now that this decision has been made in ad$ance, the studio e*ecuti$es can work backward to determine which film9s< to finance. =ecause the bud"et increase for the bi"6 bud"et mo$ie would not be appro$ed, its e*pected profits are %-?- million 6 %,'@ million G %I- million. Assumin" the re+uest for additional funds for the smaller films are appro$ed, their e*pected combined profits are e+ual to %--5 million 6 %,?@ million G %&5 million. Absent risk considerations, therefore, the e*ecuti$es would appro$e the bi"6 bud"et mo$ie.

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

hen the primary decision a mana"er must make in$ol$es one or more se+uential decisions, the mana"er should use backward induction. 4pecifically, he(she should determine what he(she would do if confronted with the last decision in the chain of e$ents and work backward to the primary decision.

5,

M 4imi% %1 Mi%im 4 )wo other simple tools for makin" decisions under risk and uncertainty are the m 4imi% and mi%im 4 methods. .nfortunately, as youll soon see, whereas mana"ers are attracted to these tools because of their simplicity, they suffer because of their simplicity and are not recommended. .nder ma*imin, the mana"er lays out the possible outcomes associated with $arious alternati$es. 1e(she identifies the worst possible outcome associated with each alternati$e and selects the alternati$e with the best worst6case scenario 9hence, the mana"er m 4imi3es the mi%imum outcome<. 7ets work throu"h a +uick e*ample. A mana"er is choosin" between three pro2ects 9A, =, and C<. =y workin" with accountin", the mana"er identifies the annual after6ta* cash flows associated with each pro2ect. )he states of nature that dri$e that cash flows are ranked from least fa$orable 9,< to most fa$orable 9?<. )hese appear in )able '. T "2e 9 S* *e of N *0re Pro>e-* A Pro>e-* ' Pro>e-* C 1 2 5 %, million 6 %5 million %A million %? million

-?2 mi22io% 6%, million

-?9 mi22io% 6%@.' million %5 million -?6 mi22io% %@ million

%- million

.sin" ma*imin, the mana"er bases his(her decision on the worst case scenario. 1ere, pro2ect A results in a potential loss of %- million whereas pro2ects = and C could potentially result in losses of %' million and %? million, respecti$ely. 1ence, the mana"er decides to "o with pro2ect A because it has the most fa$orable worst case scenario.

5-

In addition to its simplicity, ma*imin does not re+uire the decision6maker to know the probability of each outcome, which adds to its appeal. 1owe$er, this is one of its weaknesses. As we criti+ue ma*imin, we must note that o%2# the worst case scenarios matter. It i"nores not only other potential cash flows but also the likelihood that the worst case scenario is "oin" to occur. 7ets use an e*a""erated e*ample to illustrate the problems with ma*imin. 4uppose the mana"er is choosin" between two alternati$es. )he cash flows associated with each alternati$e appear in )able A. And, to make matters worse, lets assume the probability state of nature T, is "oin" to occur is , in , million. T "2e : S* *e of N *0re A2*er% *ive A A2*er% *ive ' 1 2 ?3@2 ?1@@ mi22io%

?3@1 -?3@1

.nder the ma*imin criterion, Alternati$e A would be selected because its worst case scenario is better than =s. )he fact that state of nature T- "enerates %,@@ million 9as compared to %.@- for A< is completely i"nored. :oreo$er, the fact that state of nature T, is hi"hly unlikely to occur is ne$er factored into the decision. Another simple tool is minima*. 1ere, the mana"er seeks to minimi3e the opportunity cost of makin" the wron" decision. 7ets return to the scenario in )able A to show how minima* works. e will show the ori"inal table and then use it to construct

the minima* table 9)able D<. If state of nature T, were to appear, the best solution would be to "o with pro2ect A because it results in the smallest loss. If the mana"er had chosen pro2ect A, therefore, the opportunity cost of selectin" A is %@ 9i.e. he(she could not ha$e benefited by selectin" another pro2ect<. 1owe$er, had the mana"er selected =, he(she

55

would ha$e lost %5 million more than if he(she had chosen A. 7ikewise, had he(she chosen C, the mana"er would lose %- million more than if he(she had selected A. T "2e A S* *e of N *0re Pro>e-* A Pro>e-* ' Pro>e-* C 1 6%- million 6%' million 6%? million 2 6%, million 5 %, million 6 %5 million %A million %? million

6%@.' million %5 million %@ million %- million

S* *e of N *0re Pro>e-* A Pro>e-* ' Pro>e-* C

1 %@

2 %, million

5 %- million

?5 mi22io%
%@

?5 mi22io% %@.' million %@ ?2 mi22io% %@

%, million

?2 mi22io%

.sin" minima*, the ob2ecti$e of the mana"er is to mi%imi3e the m 4imum opportunity cost associated with each pro2ect. For e*ample, by choosin" pro2ects A or =, the mana"er could miss out on as much as %5 million. 1owe$er, by makin" the wron" decision, the mana"er could ne$er miss out by more than %- million by choosin" C. 1ence, usin" minima*, the mana"er would choose pro2ect C. A"ain, as with ma*imin, the weakness of minima* lies in the fact that it i"nores the probabilities associated with each state of nature and focuses only on a sin"le outcome. In this case, C would be the recommended alternati$e e$en if the odds that states of nature , and ? were ten million to one and the likelihood of state of nature T5 occurrin" was II.IIBU )he lesson to be learned is that, like the payback method described in the capital bud"etin" chapter,

5?

mana"ers should not be seduced by a methods simplicity6666if a decision6makin" tool seems too easy, it probably isU

IMPORTANT IMP&ICATIONS FOR THE MANAGER>

,. .sin" a ma*imin criterion, the mana"er sorts out the $arious outcomes associated with alternati$es. 1e(she then chooses the alternati$e with the most fa$orable worst case scenario. -. .sin" a minima* criterion, the mana"er sorts out the $arious outcomes associated with alternati$es. For each Vstate of natureW, he(she determines the opportunity cost associated with makin" the wron" decision 9i.e. the difference in profits between choosin" the ri"ht alternati$e $ersus the wron" alternati$e<. )he mana"er identifies the ma*imum opportunity cost associated with each decision and chooses the alternati$e with the lowest ma*imum opportunity cost. 5. )he primary limitation of the ma*imin and minima* decision criteria is that they focus only on one outcome to the e*clusion of all others and do not incorporate the likelihood the outcome will occur.
SUMMARY ,. A mana"er can use a decision tree to lay out the outcomes associated with a decision. )o build a decision tree, the mana"er must determine the factors that influence the cash flows associated with a decision, infer the probability the e$ent will occur, and estimate the cash flows that will e*ist if the e$ent occurs. -. hen the probabilities of the outcomes associated with an initiati$e $ary, the proper method to assess the mean outcome is to calculate the e*pected $alue. )he

5'

e*pected $alue of a list of outcomes is a wei"hted a$era"e calculated by summin" the outcomes multiplied by their e*pected probabilities. 5. )he le$el of absolute risk associated with a decision can be inferred from the standard de$iation. )he lar"er the standard de$iation, the more risk associated with the decision. ?. In choosin" between alternati$es, the le$el of relati$e risk can be inferred from the coefficient of $ariation. )his is calculated as the standard de$iation di$ided by the e*pected $alue. It reports the dispersion amon" outcomes for each unit of e*pected $alue. '. )he $alue of information is the difference between the e*pected $alue of the alternati$e with information less the e*pected $alue of the alternati$e without information. A. hen mana"ers must make se+uential decisions, they should do so usin" backward inductionC be"innin" with the last decision on the decision tree and workin" backward until they reach the primary decision.

D. .sin" the ma*imin criterion, the mana"er chooses the alternati$e that pro$ides the most fa$orable of the worst case scenarios. .sin" the minima* criterion, the mana"er determines the opportunity cost associated with makin" the wron" decision in each possible scenario, identifies the hi"hest opportunity cost for each alternati$e, and selects the alternati$e that yields the lowest ma*imum opportunity cost. )he weakness in either of these decision criteria is that they i"nore all but one outcome and do not factor in the probability it will occur.

5A

Mi%i-C ,e: &0<< <e De2iver# Servi-e

As a $eteran business tra$eler, 4amuel Clayton had an idea for a business enterprise. )ired of ha$in" the airlines lose his lu""a"e in transit, Clayton considered creatin" a lu""a"e deli$ery ser$ice. For a price of %5@(ba", his ser$ice would pick up the lu""a"e at the tra$elers home and deli$er it to the indi$iduals destination. 1is preliminary in$esti"ation su""ested $ariable costs of %-@(ba" and annual fi*ed costs of %'@,@@@. )he $olume of business would depend on the le$el of interest in this type of ser$ice and the state of the economy. If the le$el of interest was hi"h, 4amuel belie$ed he could "enerate a $olume of -',@@@ ba"s(year in a boomin" economy, -@,@@@ ba"s(year in a normal economy, and ,D,'@@ ba"s(year in a recession. If the le$el of interest was moderate, he anticipated an annual $olume of ,',@@@ ba"s in a boomin" economy, ,@,@@@ ba"s in a normal economy, and A,-'@ ba"s in a recession. Finally, if the interest le$el was low, 4amuel e*pected to "enerate -,'@@ ba"s(year in a boomin" economy, -,@@@ ba"s(year in a normal economy, and '@@ ba"s(year in a recession. Clayton thou"ht there was a A@B likelihood that interest in his ser$ice would be hi"h, a 5@B chance of moderate interest, and a ,@B probability that interest would be low. =ased on an e*amination of historical economic data, Clayton thou"ht the likelihood of a boomin" economy was -@B and the likelihood of a recession was also -@B. 4tartin" up his business would be a full6time $enture. Clayton would not start up the lu""a"e deli$ery ser$ice unless it could increase his income beyond the %D',@@@ annual salary he currently recei$ed. =ecause he is uneasy about +uittin" his 2ob for a potentially risky business $enture, 4amuel spoke with a market research firm about

5D

conductin" a study to determine the le$el of interest in his business. )he market research study would cost %5',@@@. 4hould Clayton start up the lu""a"e deli$ery business0 4hould he pay for the market research study0

PRO'&EMS ,. A computer software company has to decide which of two ad$ertisin" strate"ies to adopt> )V commercials or newspaper ads. 4ales depend on the total $iewership when the commercials are run, and the total readership when the newspaper ads appear. H*perience dictates the correspondin" le$el of sales when $iewership(readership is hi"h, medium, or low> )V Commercials Viewership 1i"h :edium 7ow 4ales %,A,@@@ %,-,@@@ %&,@@@ Newspaper Ads #eadership 1i"h :edium 7ow 4ales %,-,@@@ %,@,@@@ %&,@@@

:edia reports show that $iewership is hi"h 5@B of the time, medium ?@B of the time, and low 5@B of the time. Newspaper readership is hi"h ?@B of the time, medium ?@B of the time, and low -@B of the time.

5&

)he cost of the tele$ision commercials is %',@@@, whereas the cost of the newspaper ads is %,'@@. Calculate the e*pected profit, standard de$iation, and coefficient of $ariation. hich ad$ertisin" strate"y would you recommend0

-. A manufacturer of di"ital cameras is tryin" to decide whether to adopt a hi"h6price strate"y or a low6price strate"y. )he firmXs profits depend on the competitorXs reaction to the firms strate"y 9your competitor must also decide whether to use a hi"h6 or low6price strate"y< and the state of the economy 9either a boomin" economy, a normal economy, or a recession<. If the firm and its competitor adopt a hi"h6price strate"y, then the firms profits will e+ual %A@,@@@ in a boomin" economy, %?@,@@@ in a normal economy, and %-@,@@@ in a recession. If the firm adopts a hi"h6price strate"y and its competitor "oes with the lower price, the firms profits will e+ual %'@,@@@ in an economic boom, %5@,@@@ in a normal economy, and %-@,@@@ in a recession. )he likelihood that the competitor will "o with a hi"h6price strate"y if the firm does is A@B. Assumin" the firm "oes with a low6price strate"y and its competitor adopts a hi"h6price strate"y, the firms profits will be %'@,@@@ in a boomin" economy, %?@,@@@ in a normal economy, and %-',@@@ in a recession.

5I

If its competitor uses the low6price strate"y at the same time the firm does, the firms profits will be %5',@@@ in a boom, %5@,@@@ in a normal economy, and %-',@@@ in a recession. )he likelihood that its competitor will "o with a low6price strate"y if the firm does is &@B. 1istorical data shows that the probability of an economic boom in any "i$en year is 5@B and the probability of a recession is -@B. Calculate the e*pected $alue, standard de$iation, and coefficient of $ariation associated with each strate"y. hich strate"y would you recommend0 H*plain.

5. 8i"i:usic is a manufacturer of :;5 players. It has de$eloped a player that can hold up to three times the $ideo and audio ima"es of competitors brands. )he company is considerin" applyin" for a patent. )he estimated cost of applyin" for a patent is %-@,@@@. If the patent is appro$ed, 8i"i:usic belie$es it can earn a profit contribution of %,'@(unit and sell two million units(year o$er the -@6year life of the patent. Con$incin" the ..4. ;atent and )rademark Office that their product is patentable is not a "i$en. Followin" consultations with patent lawyers, 8i"i:usic belie$es there is a 5@B chance it will obtain a patent. :ana"ement e*pects the profit contribution will fall to %'@(unit after the patent e*pires and unit sales will fall to '@@,@@@. 4imilarly, if 8i"i:usic "oes into production without

?@

seekin" a patent, it e*pects to earn %,'@(unit and sell - million units for three years, after which competition will reduce 8i"i:usics profit contribution and unit sales to %'@(unit and '@@,@@@ units, respecti$ely. )he .4;)O publishes all patent filin" applications ,& months after filin". 8i"i:usic is concerned this will "i$e competitors ad$ance notice of its inno$ation. If 8i"i:usics patent application is not appro$ed, competitors will manufacture their own brands one year earlier than would normally be e*pected. 8i"i:usic also worries about the possibility of patent infrin"ements. Competitors may decide to manufacture their own brands and fi"ht a le"al battle o$er the infrin"ement char"e. A prolon"ed le"al battle could cost 8i"i:usic %-'@ million. If 8i"i:usic wins the le"al battle, it can obtain an in2unction a"ainst the firm $iolatin" the patent and obtain le"al dama"es that essentially restore its profit contribution to its pre$ious le$el throu"hout the infrin"ement period. In other words, it will not reco$er the le"al e*penses, but can retain its monopoly position for the remainder of the patent. )he company belie$es there is a -'B likelihood a competitor will $iolate the patent. If this should occur, le"al e*perts belie$e 8i"i:usics probability of ha$in" its patent upheld in court to be &@B. a. Create a spreadsheet to determine whether 8i"i:usic should fi"ht a le"al battle o$er infrin"ements in each year of its patent 9i.e. is it worthwhile to fi"ht an infrin"ement that occurs in the patents last year, ne*t6to6last year, etc.0<. Assume a cost of capital of &B. b. 4hould 8i"i:usic seek a patent or "o directly into production0

?,

?. =aby #est, Inc., a manufacturer of car seats for babies, is a defendant in a product liability case. )he plaintiff and defendant are preparin" for trial, but a 2ury has not yet been selected. =ased on e*tensi$e communications with their attorney, the CHO belie$es there is a ,@B chance a 2ury will award the plaintiff %' million, a 5@B chance it will award %, million, a 5@B chance it will award %'@@,@@@, and a 5@B chance it will award %@. 4ustoko$ich !ury Consultin" Associates has offered its ser$ices. In preliminary meetin"s, the consults claimed their ser$ices would reduce the likelihood of the %' million award to 3ero percent and increase the likelihood of no award to ?@B. the ma*imum =aby #est should be willin" to pay for this ser$ice0 hat is

'. All )hin"s Christmas is preparin" for the upcomin" holiday season. :ana"ement is tryin" to decide if it should offer "ift wrappin" as a free ser$ice durin" checkout. 1istorically, the store had not "ift6wrapped its items but offered "ift6wrappin" at an additional char"e. #ou"hly ,'B of purchasers paid e*tra for the "ift6wrappin", which "enerated a profit contribution of %-(item 9the cost of "ift6wrappin" was %.'@(unit<. )he a$era"e profit contribution 9e*cludin" "ift6wrappin"< was %,'(item. If it offers complimentary "ift6wrappin", mana"ement belie$es there is a -'B probability it will sell 5,@@@ items, a -'B chance it will sell -,'@@ items, a 5@B chance it will sell -,@@@ items, and a -@B chance it will sell ,,@@@ items. If it does not offer complimentary "ift6wrappin", it e*pects a ,@B chance it will sell 5,@@@ items, a -@B chance it will sell -,'@@ items, a ?@B chance it will sell -,@@@ items, and a 5@B chance it will sell ,,@@@ items.

?-

4hould All )hin"s Christmas offer complimentary "ift6wrappin"0

A. =ill is a seasonal farmer and "rows $e"etables durin" the sprin" and summer to sell at the local farmers market. Accordin" to $arious sources 9;un*sutawney ;hil and the Farmers Almanac<, there is a chance of a late sprin" frost durin" the first week of April. =ill could either plant his $e"etables now 9mid6:arch<, after the predicted frost 9mid6 April<, or :ay ,st. If =ill planted now, there would be a 5@B chance of a sprin" frost. If the frost hit, =ill would ha$e to replant. 1e could either replant immediately after the frost or wait two weeks to ensure the cold weather had passed. If he replanted immediately after the frost, there would still be a -@B chance of a frost. If he waited two weeks after the frost, there would only be a 'B chance of another frost. If he waited until :ay ,st to plant, he could a$oid a frost alto"ether. )he problem =ill faces lies in the fact that he does not ha$e a "reenhouse, while most of the $endors in the farmers market "row their $e"etables in a "reenhouse and do not ha$e to worry about the possibility of a frost. If =ill plants now and the frost does not hit, his $e"etables will be ready for the openin" week at the farmers market. If the frost does hit, =ills $e"etables will not be ready until a month after the market opens. )here is some possibility he could be ready for the openin" week of the farmers market if he immediately replants around April ,. If =ill waits and plants in mid6April, his $e"etables still will not be ready until a month after the market opens. If he plants in April and suffers a frost in mid6April, his $e"etables will not be ready until si* weeks after the market opens. )he same is true if he a$oids the frost alto"etherC his crops will not be ready until si* weeks after the market opens. In either case, most of the other $endors

?5

will ha$e established customers and =ill will ha$e to reduce his price by -@B to "ain market share. :oreo$er, if =ill misses a month at the market, he will sell 5@B less $olume than he has predicted. If he misses si* weeks, he will sell ?@B less. =ill will also incur replantin" costs of %,@@ each time he has to replant. If =ill plants early and misses the frost, he will sell ,,'@@ pounds at %-(lb.

hen should =ill plant his $e"etables0

D. =io!oe is a company known for its ability to produce rice. Its operation a$era"es ,@B hi"her yields than the industry a$era"e. =io!oe wants to know if it should plant a rice that is resistant to sheath bli"ht. 4heath bli"ht 9#hi3octonia solani< is a fun"us that feeds off rice. Once humidity reaches I'B, the sheath bli"ht infection be"ins to "row rapidly and will decrease yields dependin" on the se$erity of the infection. 1owe$er, the rice has to be e*posed to the fun"us before the infection can occur. =io!oe belie$es that there is a ?@B chance the rice will be e*posed to the fun"us. If the rice is infected with sheath bli"ht, =io!oe is estimatin" ,,@ bushels(acre compared to ,I@ bushels(acre if it isnt affected in a ,@@6acre plot. #esistant rice costs %DD'(acre to produce compared to %'-@(acre for rice that isnt resistant. =oth breeds will "enerate %?.D'(bushel. =io!oe is tryin" to decide which breed to produce for this year.

4hould =io!oe plant a breed that is resistant to sheath bli"ht0

??

&. Office ;artners is considerin" e*tendin" its market into de$elopin" countries that show the hi"hest percenta"e "rowth in personal computers. .nfortunately, because it lacks historical data, it can only make sales pro2ections based on $arious assumptions. At the present time, Office ;artners has narrowed down its market to either Hli3ea or Hast Yatia. )he net present $alues from market e*pansion in either country appear below. S 2e, Pro>e-*io%, Bi% mi22io%, of 1o22 r,C Co0%*r# E2i7e E ,* K *i 6%5' 6%,6%,@ 6%, %6, %, %-' %,A %A@ %-' )er# Poor Poor Aver <e Goo1 )er# Goo1

a. If you were to make your decision $ia ma*imin, which country would you choose0 b. 4uppose the probabilities of each sales le$el was as follows> Very ;oor> ;oor> A$era"e> Qood> Very Qood> -B ,'B ''B --B 'B

1ow would this affect your recommendation0

?'

HANDS-ON EXERCISES
De-i,io% Tree, 8ecision trees represent a con$enient way to lay out the outcomes associated with a decision. )he first branch defines the decision the mana"er wishes to make. 4ubse+uent branches establish the factors that affect the outcomes of the decision. #ead o$er the below scenario. ell build the decision tree based on the information.

A firm is tryin" to decide whether to build a manufacturin" plant in 8etroit, :ichi"an or the )win Cities in :innesota. If it locates in 8etroit, its fi*ed costs will e+ual %5@@,@@@ and it will incur $ariable costs of %,-(unit. If the plant is located in :innesota, it will incur fi*ed costs of %A@@,@@@ and $ariable costs of %,@(unit. 1owe$er, there is a -@B chance a decrease in supply will dri$e up $ariable costs. If so, the $ariable costs will rise to %,? in 8etroit and %,5 in the )win Cities. .nit sales will depend on the state of the economy. If economic conditions are normal, the firm e*pects to sell 5'@,@@@ units in 8etroit and 5D',@@@ in the )win Cities. If the economy is in a recession, it anticipates unit sales of -@@,@@@ units in 8etroit and ,&@,@@@ in the )win Cities. 1istorically, recessions ha$e been known to occur once e$ery four years. )he unit price will be %-@ in either location unless a price war occurs, in which case the price will fall to %,' in 8etroit and %,5 in the )win Cities. hen price wars occur, unit sales tend to rise by ,@B. ;rice wars tend to occur once e$ery three years. a. hat decision is the firm tryin" to make0 Indicate each alternati$e on one of the branches.

?A

b. )he first factor that could influence the firms profits is the cost structure. 7ist each cost structure in the respecti$e branch and the probability it will occur.

8etroit

)win Cities

?D

c. )he ne*t factor that may influence profits is the state of the economy. 7ist each possibility and the probability it will occur on one of the branches.

7ow Cost Fi*ed> %5@@,@@@ Variable> %,-(unit ; G .&@ 1i"h Cost Fi*ed> %5@@,@@@ Variable> %,?(unit ; G .-@

8etroit

)win Cities 7ow Cost Fi*ed> %A@@,@@@ Variable> %,@(unit ; G .&@

1i"h Cost Fi*ed> %A@@,@@@ Variable> %,5(unit ; G .-@

?&

c. )he last factor that affects profitability is the price war. 7ist each possibility and its correspondin" probability in each branch.

Normal S G 5'@,@@@ ; G .D' #ecession S G -@@,@@@ ; G .-'

7ow Cost Fi*ed> %5@@,@@@ Variable> %,-(unit ; G .&@

De*roi*
1i"h Cost> Fi*ed> %5@@,@@@ Variable> %,?(unit ; G .-@ 7ow Cost> Fi*ed> %A@@,@@@ Normal> Variable> %,@(unit S G 5D',@@@ ;G; .&@ G .D'

Normal S G 5'@,@@@ ; G .D' #ecession S G -@@,@@@ ; G .-'

Normal S G 5D',@@@ ; G .D' #ecession S G ,&@,@@@ ; G .-' Normal S G 5D',@@@ ; G .D'

Twi% Ci*ie,

ZZZ

1i"h Cost> Fi*ed> %A@@,@@@ Variable> %,5(unit ; G .-@

#ecession S G ,&@,@@@ ; G .-'

?I

a. Calculate the profit and probability associated with each branch. 9#ecall that the probability of independent e$ents is the product of the indi$idual probabilities.

;rofit

;rob.

DDDDD DDDD
Normal S G 5'@,@@@ ; G .D' #ecession S G -@@,@@@ ; G .-'

ZZZZZ ZZZZZ ZZZZZ

ZZZZ ZZZZ ZZZZ

7ow Cost Fi*ed> %5@@,@@@ Variable> %,-(unit ; G .&@

De*roi*
1i"h Cost> Fi*ed> %5@@,@@@ Variable> %,?(unit ; G .-@

Normal S G 5'@,@@@ ; G .D' #ecession S G -@@,@@@ ; G .-'

ZZZZZZ ZZZZ ZZZZZ ZZZZ ZZZZZ ZZZZ ZZZZZ ZZZZZ

#ecession S G ,&@,@@@ ; G .-'

ZZZZ ZZZZ Twi% Ci*ie,

7ow Cost> Fi*ed> %A@@,@@@ Variable> %,@(unit Normal> ; G .&@ S G 5D',@@@ ; G .D'

Normal S G 5D',@@@ ; G .D'

ZZZ ZZZZZ ZZZ ZZZZZ ZZZ ZZZZZ ZZZZ

ZZZ ZZZZ
1i"h Cost> Fi*ed> %A@@,@@@ Variable> %,5(unit ; G .-@

Normal S G 5D',@@@ ; G .D'

ZZZZZ ZZZ
#ecession S G ,&@,@@@ ; G .-'

ZZZZZ ZZZ

'@

ZZZZZ ZZZZ

E4.e-*e1 ) 20e a. Fill in the profits for each of the below scenarios. Calculate the a$era"e profit at each location. De*roi* S-e% rio 7ow Cost( Normal Hconomy( No ;rice ar 7ow Cost( #ecession( No ;rice ar 7ow Cost( Normal Hconomy( ;rice ar 7ow Cost( #ecession( ;rice ar 1i"h Cost( Normal Hconomy( No ;rice ar 1i"h Cost( #ecession( No ;rice ar 1i"h Cost( Normal Hconomy( ;rice ar O0*-ome Twi% Ci*ie, O0*-ome

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

',

1i"h Cost( #ecession( ;rice ar :ean ;rofit>

ZZZZZZZ ZZZZZZZ

ZZZZZZZZ ZZZZZZZZ

b. )he below table shows both the outcomes and the probability that each outcome will occur. De*roi* Twi% Ci*ie, S-e% rio 7ow Cost( Normal Hconomy( No ;rice ar 7ow Cost( #ecession( No ;rice ar 7ow Cost( Normal Hconomy( ;rice ar 7ow Cost( #ecession( ;rice ar 1i"h Cost( Normal Hconomy( No ;rice ar 1i"h Cost( #ecession( No ;rice ar 1i"h Cost( Normal Hconomy( ;rice ar 1i"h Cost( #ecession( ;rice ar O0*-ome Pro" "i2i*# O0*-ome Pro" "i2i*#

%-,'@@,@@@

.?@-@

%5,,'@,@@@

.?@-@

%,,5@@,@@@

.,5?@

%,,-@@,@@@

.,5?@

%&'',@@@

.,I&@

%A5D,'@@

.,I&@

%5A@,@@@

.@AA@

9%A,@@@<

.@AA@

%,,&@@,@@@

.,@@'

%-,@-',@@@

.,@@'

%I@@,@@@

.@55'

%AA@,@@@

.@55'

%&',@@@

.@?I'

9%A@@,@@@<

.@?I'

9%&@,@@@<

.@,A'

9%A@@,@@@<

.@,A'

'-

hich outcome is least likely to occur0

hich outcome is most likely to occur0

c. =ased on your answer to b, do you think the mean outcome is an accurate assessment of the a$era"e profit at each location0 hen the mean of a set of outcomes is calculated, it implicitly assumes the probability each outcome will occur is the same. hen the probabilities differ, as they usually do for business decisions, the appropriate method for determinin" the a$era"e outcome is to calculate the e4.e-*e1 v 20e 9J<. )he e*pected $alue is a wei"hted a$era"e. It is calculated by multiplyin" each outcome by the probability it will occur and then summin" them up, or> = Pi X i
i =, n

d. Calculate the e*pected $alue for each location. S-e% rio 7ow Cost( Normal Hconomy( No ;rice ar 7ow Cost( #ecession( No ;rice ar 7ow Cost( Normal Hconomy( ;rice ar 7ow Cost( #ecession( ;rice ar 1i"h Cost( Normal Hconomy( No ;rice ar 1i"h Cost( #ecession( No ;rice ar De*roi* O0*-ome Pro" "i2i*# Twi% Ci*ie, O0*-ome Pro" "i2i*#

%-,'@@,@@@

.?@-@

%5,,'@,@@@

.?@-@

%,,5@@,@@@

.,5?@

%,,-@@,@@@

.,5?@

%&'',@@@

.,I&@

%A5D,'@@

.,I&@

%5A@,@@@

.@AA@

9%A,@@@<

.@AA@

%,,&@@,@@@

.,@@'

%-,@-',@@@

.,@@'

%I@@,@@@

.@55'

%AA@,@@@

.@55'

'5

1i"h Cost( Normal Hconomy( ;rice ar 1i"h Cost( #ecession( ;rice ar H*pected Value> S* %1 r1 Devi *io%

%&',@@@

.@?I'

9%A@@,@@@<

.@?I'

9%&@,@@@< ZZZZZZZZ

.@,A'

9%A@@,@@@< ZZZZZZZZZZ

.@,A'

a. 7ets alter the cash flows for the )win Cities. )he cash flows at the two locations and their respecti$e probabilities are shown below. Calculate the respecti$e e*pected $alues. De*roi* S-e% rio 7ow Cost( Normal Hconomy( No ;rice ar 7ow Cost( #ecession( No ;rice ar 7ow Cost( Normal Hconomy( ;rice ar 7ow Cost( #ecession( ;rice ar 1i"h Cost( Normal Hconomy( No ;rice ar 1i"h Cost( #ecession( No ;rice ar O0*-ome Pro" "i2i*# Twi% Ci*ie, O0*-ome Pro" "i2i*#

%-,'@@,@@@

.?@-@

%5,@@@,@@@

.?@-@

%,,5@@,@@@

.,5?@

%,,,@@,@@@

.,5?@

%&'',@@@

.,I&@

%'A,,@@@

.,I&@

%5A@,@@@

.@AA@

9%',,D'@<

.@AA@

%,,&@@,@@@

.,@@'

%,,A'@,@@@

.,@@'

%I@@,@@@

.@55'

%?A-,'@@

.@55'

'?

1i"h Cost( Normal Hconomy( ;rice ar 1i"h Cost( #ecession( ;rice ar H*pected Value>

%&',@@@

.@?I'

9%&I@,-'@<

.@?I'

9%&@,@@@< ZZZZZZZ

.@,A'

9%D5?,I5,.'@< .@,A' ZZZZZZZ

b. If your recommendation were based e*clusi$ely on the a$era"e annual profit at each location, which location would you recommend0

c. Considerin" all of the information before you, which location would you recommend0 H*plain.

d.

hat do your answers to +uestions b and c su""est about usin" e*pected $alue e*clusi$ely to make your decision0

e.

Qi$en all of the infomation, why mi"ht someone recommend 8etroit0 )he )win Cities0

If you ha$e a preference in this scenario, you are considerin" risk alon" with e*pected $alue. )he more widely dispersed the outcomes, the "reater the risk. 4tandard de$iation 9N< calculates the dispersion of outcomes around the mean. It is calculated as>

P 9X
i =, i

< -

As the e+uation implies, the "reater the difference between the outcomes and the mean, the "reater 9 X i < - . )herefore, as the standard de$iation increases, the dispersion of outcomes increases, which implies more risk.

''

f. Calculate the standard de$iations for 8etroit and the )win Cities.

8ecision6makers may not always seek to a$oid risk. In this scenario, whereas one decision6maker may choose 8etroit because the outcomes are closer to"ether, another decision6maker may prefer the )win Cities because it has the potential to pay off better than 8etroit. In other words, the person who prefers the )win Cities is willin" to risk one of the lower payoffs in the )win Cities for a chance at one of the hi"her payoffs. An indi$idual who prefers to a$oid risk 9and therefore prefers a smaller standard de$iation< has ri,! ver,e preferences. An indi$idual who prefers risk 9and therefore prefers a lar"er standard de$iation< has ri,!-,ee!i%< preferences. Finally, someone who is indifferent between standard de$iations when the alternati$es ha$e the same e*pected $alue is ri,! %e0*r 2.

'A

Coeffi-ie%* of ) ri *io% 7ocation A> Outcomes ,. %@ -. 6%,@@ 5. %5'@ ?. %'@ '. %@ 7ocation => Outcomes ,. %,,@@@,,@@ -. %III,&@@ 5. %,,@@@,'@@ ?. %III,I'@ '. %III,I@@ ;robability of Occurrin" .,@ .,@ .-@ .-@ .?@ ;robability of Occurrin" .,@ .,@ .-@ .-@ .?@

a. Calculate the e*pected $alue and standard de$iation for each of the locations. H*pected Value A> ZZZZZZ 4tandard 8e$iation ZZZZZZZZ

'D

=>

ZZZZZZ

ZZZZZZZZ

b. If you were to assess risk e*clusi$ely on the si3e of the standard de$iation, which location would you ha$e indicated as the most risky0

c. As you "lance o$er the abo$e information, would you, in fact, identify this location as the more risky of the two0

d. Is a simple comparison of standard de$iation fi"ures sufficient to assess risk0 why not0

hy or

4tandard de$iation measures the actual dispersion of outcomes around the mean. In this manner, it is a measure of ",o20*e ri,!. In this scenario, howe$er, a standard de$iation of %,?' when the e*pected $alue is %D@ is, on a relati$ely basis, is fairly risky. On the other hand, a standard de$iation of %-?@ when the e*pected $alue is %,,@@@,@?@ is pretty close to a sure bet. hen the e*pected $alues of alternati$es differ, mana"ers may prefer to measure the le$el of re2 *ive ri,!. )his can be assessed by calculatin" the coefficient of $ariation 9R<. )he coefficient of $ariation is determined by di$idin" the standard de$iation by the e*pected $alue, or> R G N(J. e. Calculate the coefficient of $ariation for each location. Interpret each number.

'&

De-i,io% Tree, wi*+ Se80e%*i 2 De-i,io%, A mo$ie studio is tryin" to decide whether to finance a %,'@ million bi"6bud"et film or two smaller films costin" %D@ million each. )he studio e*ecuti$es anticipate a subse+uent re+uest for an additional %'@ million for the bi"6bud"et film and a combined %-' million for the two smaller films well after the ori"inal financin" has been appro$ed and production is under way. If the additional funds for the bi"6bud"et film are appro$ed, the studio e*ecs e*pect an &@B chance it will "ross %5@@ million, a ,@B chance it will "ross %-@@ million, and a ,@B chance it will "ross %&@ million. If the bud"et increase is not appro$ed, the probabilities of a %5@@ million "ross fall to A@B, with the likelihood of %-@@ million risin" to -'B and the probability of an %&@ million "ross increasin" to ,'B. If the two smaller films are financed and bud"et increases of a combined %-' million are appro$ed, the e*ecuti$es belie$e there is a A@B chance the films will collecti$ely "ross %5@@ million. )his probability falls to 5@B if the bud"et increases are not appro$ed. 4imilarly, the likelihood the smaller films will "ross a combined %-@@ million is e*pected to be 5@B if the bud"et increase is appro$ed and ?@B if it is not appro$ed. Finally, if the additional funds are appro$ed, the likelihood the films will "ross %&@ million is ,@B and 5@B if not appro$ed.

'I

A"ain, lets build the decision tree from scratch. hat decision is the mo$ie studio tryin" to make0 7ist each alternati$e on one of the branches.

After the film is appro$ed, the studio anticipates re+uests for additional fundin"> %'@ million if the bi"6bud"et film is appro$ed and %-' million 9combined< if the two smaller bud"et films are appro$ed. 7ist the se+uential decisions on the ne*t set of branches.

=i"6bud"et Film %,'@ million

A@

)wo %D@ million films

7ist the anticipated "ross and the probabilities those "rosses will be reali3ed on the correspondin" branches. Gro,,
ZZZZZZZZ Appro$e Additional %'@ million 'i< '01<e* Fi2m ?19@ mi22io% 8o not appro$e Additional bud"et

Pro" "i2i*#
ZZZZZZZ

ZZZZZZZZ

ZZZZZZZ

ZZZZZZZZ ZZZZZZZZ ZZZZZZZZ ZZZZZZZZ ZZZZZZZZ

ZZZZZZZ ZZZZZZZ ZZZZZZZ ZZZZZZZ ZZZZZZZ

Two ?A@ mi22io% Fi2m,

Appro$e Additional %-' million

ZZZZZZZZ ZZZZZZZZ

ZZZZZZZ ZZZZZZZ

8o not Appro$e Additional =ud"et

ZZZZZZZZ ZZZZZZZZ

ZZZZZZZ ZZZZZZZ

ZZZZZZZ

ZZZZZZZ

A,

Notice that you cant determine the e*pected $alue, standard de$iation, and coefficient of $ariation for the bi"6bud"et and two smaller bud"et films until you first decide how to deal with the re+uest for additional financin". 7ist the outcomes and probabilities associated with the re+uest for additional fundin" for the bi"6bud"et film. Gro,, Pro" "i2i*# ZZZZZZZZZ %'@ million Appro$ed ZZZZZZZZ ZZZZZZZ ZZZZZZZ

ZZZZZZZZ %'@ million Not Appro$ed

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

8etermine the e*pected $alue, standard de$iation, and coefficient of $ariation associated with the bud"et increase re+uest 9dont for"et to subtract the additional bud"et cost if appro$ed<

A-

H*pected Value> ZZZZZZZZZZZZZZZZZZZZZZZ 4tandard 8e$iation> ZZZZZZZZZZZZZZZZZZZZ Coefficient of Variation> ZZZZZZZZZZZZZZZZZZ ould you appro$e the bud"et increase0 H*plain. 7ist the outcomes and probabilities associated with the re+uest for additional fundin" for the smaller6bud"et film. Gro,, Pro" "i2i*# ZZZZZZZZZ %-' million Appro$ed ZZZZZZZZ ZZZZZZZ ZZZZZZZ

ZZZZZZZZ %-' million Not Appro$ed

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

8etermine the e*pected $alue, standard de$iation, and coefficient of $ariation associated with the bud"et increase re+uest 9dont for"et to subtract the additional bud"et cost if appro$ed< H*pected Value> ZZZZZZZZZZZZZZZZZZZZZZZ 4tandard 8e$iation> ZZZZZZZZZZZZZZZZZZZZ Coefficient of Variation> ZZZZZZZZZZZZZZZZZZ

A5

ould you appro$e the bud"et increase0 H*plain.

#e6do the decision tree with the subse+uent decisions pre6determined. Gro,, %,'@ million =i"6=ud"et Additional %'@ million Not appro$ed ZZZZZZZZZ ZZZZZZZZ Pro" "i2i*# ZZZZZZZ ZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

)wo %D@ million films %-' million additional =ud"et appro$ed

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

ZZZZZZZZ

8etermine the e*pected $alue, standard de$iation, and coefficient of $ariation associated with the bi"6bud"et and two smaller6bud"et films. H*pected Value 9bi"6bud"et<> ZZZZZZZZZZZZZZZZZZZZZZZ 4tandard 8e$iation 9bi"6bud"et<> ZZZZZZZZZZZZZZZZZZZZ Coefficient of Variation 9bi"6bud"et<> ZZZZZZZZZZZZZZZZZZ

A?

H*pected Value 9two smaller films<> ZZZZZZZZZZZZZZZZZZZZZZZ 4tandard 8e$iation 9two smaller films<> ZZZZZZZZZZZZZZZZZZZZ Coefficient of Variation 9two smaller films<> ZZZZZZZZZZZZZZZZZZ

T+e ) 20e of I%form *io% A firm is considerin" launchin" a new product into the re"ion. If launched throu"hout its retail outlets, it anticipates the followin" annual outcomes and probabilities> Profi* -o%*ri"0*io% Pro" "i2i*# %- million %@.' million %@., million 9%@.- million< 9%@.' million< .'@ .-' .,@ .,@ .@'

a. Calculate the e*pected $alue.

b. )he product mana"er anticipates the "ood will ha$e a life of fi$e years, after which it will become obsolete. =ased on a cost of capital of &B, estimate the present $alue of the income stream.

A'

c. An alternati$e to launchin" the product throu"hout the re"ion is to conduct a test market in a sin"le market. )he profit contribution for the re"ion will be inferred from the followin" test market results. Te,* M r!e* Re,02* %-@@,@@@ %'@,@@@ %,@,@@@ [ %,@,@@@ I%ferre1 Re<io% 2 Profi* Co%*ri"0*io% %- million %@.' million %@., million %@ 9product will not be launched< Pro" "i2i*# .'@ .-' .,@ .,'

d. Calculate the re$ised e*pected $alue based on the results of the test market.

e. Compare the e*pected $alue with the test market results with the e*pected $alue without the test market. 1ow much should the firm be willin" to pay for the test market0

AA

M 4imi% Cri*erio% ;art I. A firm is tryin" to decide between three pro2ects 9A, =, and C<. It has identified four outcomes associated with each pro2ect. )he probabilities of each outcome are not known. S* *e of N *0re Pro>e-* A Pro>e-* ' Pro>e-* C 1 6%- million 6%' million 6%? million 2 6%, million 5 %, million 6 %5 million %A million %? million

6%@.' million %5 million %@ million %- million

a. Circle the least fa$orable outcome associated with each pro2ect. b. hich of the circled outcomes is the most fa$orable0

.nder the ma*imin criterion, the pro2ect that has the most fa$orable worst case outcome is selected.

AD

;art II. 4uppose a firm is tryin" to choose between alternati$es A and =. )he outcomes associated with each alternati$e are shown below. S* *e of N *0re A2*er% *ive A A2*er% *ive ' 1 %.@, 6%.@, 2 %.@%,@@ million

a. Circle the least fa$orable outcome associated with each pro2ect. b. c. hich of the circled outcomes is the most fa$orable0 hich alternati$e would you choose based on ma*imin0

d. ould your decision remain the same if the probability of state T, was ,@B0 ,B0 @.,B

e. =ased on the abo$e implications, what weakness is associated with the ma*imin criterion0

A&

Mi%im 4 Cri*erio% a. =ased on the below table, circle the most fa$orable outcomes correspondin" to each state of nature. S* *e of N *0re Pro>e-* A Pro>e-* ' Pro>e-* C 1 6%- million 6%' million 6%? million 2 6%, million 5 %, million 6 %5 million %A million %? million

6%@.' million %5 million %@ million %- million

b. In the below table, calculate the opportunity cost associated with choosin" the wron" alternati$e correspondin" to each state of nature. For e*ample, if state of nature T, took place, the best alternati$e is A, which loses %- million. 1ad the firm chosen A, it could not ha$e done better, so its opportunity cost is %@. 1ad it chosen =, it would lose %' million, which is %5 million worse than if it had chosen A. 1ad it chosen C, it would lose %? million, which is %- million worse than if it had chosen A. Complete the table.

S* *e of N *0re Pro>e-* A Pro>e-* ' Pro>e-* C

1 %@ %5 million %- million

2 ZZZZZ ZZZZZ ZZZZZ

5 ZZZZZ ZZZZZ ZZZZZ

6 ZZZZZ ZZZZZ ZZZZZ

c. Circle the ma*imum opportunity cost associated with each pro2ect.

AI

d.

hich pro2ect has the lowest ma*imum opportunity cost0

.sin" the minima* criterion, the pro2ect that has the lowest ma*imum opportunity cost will be selected.

e. )he below table shows the opportunity cost table. Accordin" to the table, ;ro2ect C has the smallest ma*imum opportunity cost.

S* *e of N *0re Pro>e-* A Pro>e-* ' Pro>e-* C

1 %@

2 %, million

5 %- million

?5 mi22io%
%@

?5 mi22io% %@.' million %@ ?2 mi22io% %@

%, million

?2 mi22io%

1ow mi"ht your decision chan"e if the probabilities of the states of nature were as follows0 S* *e of N *0re , 5 ? f. Pro" "i2i*# .@, .ID .@, .@, hat is the primary limitation of the minima* criterion0

D@

D,

Fi<0re 1 O0*-ome
No ;rice ;rice Normal ar %&'',@@@ ar %-,'@@,@@@

Pro" "i2i*#
.?@-@ .,I&@

Co,*
7ow 1i"h

De*roi*
%5@@,@@@ %,-(unit %5@@,@@@ %,5(unit

Twi% Ci*ie,
%A@@,@@@ %,@(unit %A@@,@@@ %,?(unit

No ;rice 7ow Cost #ecession ;rice

ar ar

%,,5@@,@@@

.,5?@

E-o%om#
Normal 5'@,@@@ units #ecession -@@,@@@ units 5D',@@@ units ,&@,@@@ units

De*roi*
Normal 1i"h Cost ;rice #ecession No ;rice ar ar No ;rice ar

%5A@,@@@ %,,&@@,@@@ %&',@@@ %I@@,@@@

.@AA@ .,@@'

Pri-e $ r
No /es %-@ %,' S \,@B %-@ %,5 S\,@B

.@?I' .@55'

;rice

ar 9%&@,@@@< .@,A' .?@-@ .,I&@ .,5?@ .@AA@ .,@@' .@?I' .@55' .@,A'

Twi% Ci*ie,
Normal 7ow Cost #ecession

No ;rice

ar

%5,,'@,@@@ %A5D,'@@ %,,-@@,@@@ 9%A,@@@< %-,@-',@@@ 9%A@@,@@@<

;rice ar No ;rice ar ;rice ar

1i"h Cost Normal #ecession

No ;rice ar ;rice ar

No ;rice ar ;rice ar

%AA@,@@@ 9%A@@,@@@< 9%A@@,@@@

D-

Fi<0re 2 9a< Fre80e%-#

E 9b< Fre80e%-#

O0*-ome

O0*-ome

D5

Fi<0re 5 a< Normal distribution Fre+uency

Outcome b< )rian"ular distribution Fre+uency

Outcome

c< .niform distribution Fre+uency

Outcome d< 7o"normal distribution Fre+uency

Outcome

D?

%D',@@@ &0<< <e De2iver# Kee. Servi-e P F ?5@;" < >o" A)C F ?2@;" <

Fi<0re 6 Gro,,
%5@@ million Appro$e Additional %'@ million 'i< '01<e* Fi2m ?19@ mi22io% 8o not appro$e Additional bud"et

Pro" "i2i*#
.&@

%-@@ million

.,@

%&@ million %5@@ million %-@@ million %&@ million %5@@ million

.,@ .A@ .-' .,' .A@

Two ?A@ mi22io% Fi2m,

Appro$e Additional %-' million

%-@@ million %&@ million

.5@ .,@

8o not Appro$e Additional =ud"et

%5@@ million %-@@ million %&@ million

.5@ .?@ .5@

D'