MGMT 20005 Assignment 1: Individual Assignment

Instructions: This is an individual assignment. The assignment involves using the decision analysis
models discussed in lectures to solve decision-making problems. You might use computer tools to
calculate the solutions.

Weight: 15% of the total grade

Format: Turnitin Assignment. Please submit your reports via Turnitin.

Due date: 5pm, Friday August 30, 2019.

Word limit: 750 (excluding diagrams and references if any). Assignments that exceed the word
limit are unacceptable unless a sound reason is provided to the coordinator.

Question 1:

A car dealer is offering the following three one-year leasing options:

Plan Fixed Monthly Payment Additional Payment per km

I $200 $0.095 per km
II $300 $0.061 for the first 6,000 kms; $0.050 thereafter
III $170 $0.000 for the first 6,000 kms; $0.140 thereafter
Suppose a customer expects to drive between 15,000 to 35,000 kms during the next year
according to the following probability distribution:

P(driving 15,000 kms) = 0.1

P(driving 20,000 kms) = 0.2
P(driving 25,000 kms) = 0.2
P(driving 30,000 kms) = 0.3
P(driving 35,000 kms) = 0.2
a. Construct a payoff table for this problem. [4 marks]
b. What is the optimal leasing option for the customer if s/he is optimistic? [2 marks]
c. What is the optimal leasing option for the customer if s/he is pessimistic? [2 marks]
d. What is the optimal leasing option for the customer if s/he bases her/his decision on the
opportunity loss criterion? [4 marks]
e. What is the optimal leasing option for the customer if s/he bases her/his decision on the
expected value criterion? [2 marks]

Question 2:

The Aurora Beverage Company is a leading player in the niche market of organic drinks. Aurora
produces a popular canned drink that targets at vegetarians. For this product, it must decide
whether to make the cans itself or buy the cans from a third-party packaging supplier. The
resulting profit is dependent upon the demand for the canned drink. The following payoff table
shows the projected profit (in thousands of dollars):

State of Nature
Low Demand Medium Demand High Demand
Decision Alternative s1 s2 s3
Make, d1 -20 40 100
Buy, d2 10 45 70
The state-of-nature probabilities are P(s1)=0.35, P(s2)=0.35, P(s3)=0.30.

a. Use a decision tree to recommend a decision according to the EMV criterion. [7 marks]
b. Use EVPI to determine whether Aurora should attempt to obtain a better estimate of
demand. [6 marks]
c. A test market study of the potential demand for the canned drink is expected to report
either a favourable (F) or unfavourable (U) conditions. The relevant conditional
probabilities are as follows:
P(F|s1)=0.1, P(U|s1)=0.9, P(F|s2)=0.4, P(U|s2)=0.6, P(F|s3)=0.6, P(U|s3)=0.4.
What is the probability that the market research report will be favourable? [5 marks]
d. What is Aurora’s optimal decision strategy with the test market study in question c?
[10 marks]
e. What is the expected value of the market research information in question c? [5 marks]

Question 3:

Suppose Amy Brown’s utility for her total wealth (denoted by A) can be represented by the utility
function U(A)=ln(A). She currently has $1,000 in cash. A business deal of interest to her yields a
reward of $100 with probability 0.5 and $0 with probability 0.5.

a. If she owns this business deal in addition to the $1,000 and considers selling the deal,
what is the smallest amount for which she would sell it (i.e., the amount of the deal such
that she is indifferent between selling and keeping the deal)? [5 marks]
b. Suppose she does not own the deal, and the price of the deal is $45. Will she buy it based
on EMV? What if she bases her decision on utility? If buying, what are the certainty
equivalent (CE) and her risk premium? [9 marks]

Hint: The following formulas might be used.

1. ! ∗ #$(&) = #$(& ) ) , #$(!) + #$(&) = #$(!&), where !, & > 0 are constants and #$ is the
natural logarithm function.
12∓√2516)7
2. The roots of the quadratic equation !. / + &. + 0 = 0 (if any) are . = where
/)
!, &, 0 are constants.

Question 4:

Robert Day, manager of Oakland real estate corporation, would like to submit a bid to purchase
a property that will be sold by sealed bid at an auction. Robert’s initial judgment is to submit a
bid of $5 million. Based on his experience, Robert estimates that a bid of $5 million will have a
0.2 probability of being the highest bid and securing the property for Oakland. The current date is
June 1. Sealed bids for the property must be submitted by August 15.

If Oakland submits the highest bid and obtains the property, the firm plans to build a complex of
luxury condominiums. However, a complicating factor is that the property is currently zoned for
single-family residences only. Robert believes that a referendum could be placed on the voting
ballot in time for the November election. Passage of the referendum would change the zoning of
the property and permit construction of the condominiums.
The sealed-bid procedure requires the bid to be submitted with a deposit for 10% of the amount
bid. If the bid is rejected, the deposit is refunded. If the bid is accepted, the deposit is the down
payment for the property. However, if the bid is accepted and the bidder does not follow through
with the purchase, the deposit will be forfeited. In this case, the property will be offered to the
second highest bidder.

To determine whether Oakland should submit the $5 million bid, Robert has done some
preliminary analysis. This preliminary work provided an estimate of 0.3 for the probability that
the referendum for a zoning change will be approved and resulted in the following estimates of
the costs and revenue that will be incurred if the condominiums are built.

Cost and Revenue Estimates

Revenue from condominium sales $15,000,000
Cost
Property $5,000,000
Construction Expenses $8,000,000
If Oakland obtains the property and the zoning change is rejected in November, Robert believes
that the best option would be for the firm not to complete the purchase of the property. In this
case, Oakland would forfeit the 10% deposit that accompanied the bid.

Because the likelihood that the zoning referendum will be approved is such an important factor
in the decision process, Robert suggested that the firm hire a market research firm to conduct a
survey of voters. The survey would provide a better estimate of the likelihood that the
referendum for zoning change would be approved. The market research firm that Oakland has
worked with in the past has agreed to do the study for $15,000. The results of the study will be
available August 1, so that Oakland will have this information before the August 15 bid deadline.
The results of the survey will be either a prediction that the zoning change will be approved or a
prediction that the zoning change will be rejected. After considering the record of the market
research firm in previous studies conducted for Oakland, Robert developed the following
probability estimates concerning the accuracy of the market research information.

P (A | s1) = 0.9 P(N | s1) = 0.1 P (A | s2) = 0.2 P(N | s2) = 0.8,
where

A= prediction of zoning changes approval

N= prediction that zoning change will not be approved
s1 = the zoning change is approved by the voters
s2 = the zoning change is rejected by the voters

Perform an analysis of the problem facing the Oakland, and prepare a report that summarizes
your findings and recommendations. Include the following items in your report:

a. A decision tree that shows the logical sequence of the decision problem. [14 marks]
b. A recommendation regarding what Oakland should do if the market research
information is not available. [7 marks]
c. A decision strategy that Oakland should follow if the market research is conducted.
[10 marks]
d. A recommendation as to whether Oakland should employ the market research firm,
along with the value of the information provided by the market research firm.
[8 marks]