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    Problems DA HW

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    Muhammad Haris
    Philip Mahn has $30,000 to invest and is deciding between a stock mutual fund or CD. The stock fund has estimated returns of 16%, 9%, or -2% depending on market conditions, which have probabilities of 0.1, 0.85, and 0.05, respectively. The CD guarantees 8% return. According to different decision rules - maximax, maximin, minimax regret, EMV, and EOL - the optimal decisions differ. EMV rule suggests investing in the stock fund.

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    Problems DA HW

    Uploaded by

    Muhammad Haris
    162 views7 pages
    Philip Mahn has $30,000 to invest and is deciding between a stock mutual fund or CD. The stock fund has estimated returns of 16%, 9%, or -2% depending on market conditions, which have probabilities of 0.1, 0.85, and 0.05, respectively. The CD guarantees 8% return. According to different decision rules - maximax, maximin, minimax regret, EMV, and EOL - the optimal decisions differ. EMV rule suggests investing in the stock fund.

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    Philip Mahn has $30,000 to invest and is deciding between a stock mutual fund or CD. The stock fund has estimated returns of 16%, 9%, or -2% depending on market conditions, which have probabilities of 0.1, 0.85, and 0.05, respectively. The CD guarantees 8% return. According to different decision rules - maximax, maximin, minimax regret, EMV, and EOL - the optimal decisions differ. EMV rule suggests investing in the stock fund.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    162 views7 pages

    Problems DA HW

    Uploaded by

    Muhammad Haris
    Philip Mahn has $30,000 to invest and is deciding between a stock mutual fund or CD. The stock fund has estimated returns of 16%, 9%, or -2% depending on market conditions, which have probabilities of 0.1, 0.85, and 0.05, respectively. The CD guarantees 8% return. According to different decision rules - maximax, maximin, minimax regret, EMV, and EOL - the optimal decisions differ. EMV rule suggests investing in the stock fund.

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    © All Rights Reserved
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    of 7

    PROBLEMS DECISION ANALYSIS

    QUESTION #1:

    One of Philip Mahn’s investments is going to mature, and he wants to determine how to invest the
    proceeds of $30,000. Philip is considering two new investments: a stock mutual fund and a one-year
    certificate of deposit (CD). The CD is guaranteed to pay an 8% return. Philip estimates the return on
    the stock mutual fund is 16%, 9%, or -2%, depending on whether market conditions are good, average
    or poor, respectively. Philip estimates the probability of a good, average, and poor market to be 0.1,
    0.85, and 0.05, respectively.

    a) Construct a payoff matrix for this problem.

    Investment: Good Average Poor


    Stock 16.0% 9.0% -2.0%
    CD 8.0% 8.0% 8.0%

    b) What decision should be made according to the maximax decision rule?

    Investment: Good Average Poor Maximum


    Stock 16.0% 9.0% -2.0% 16%
    CD 8.0% 8.0% 8.0% 8%

    According to the Maximax decision rule, Philip Mahn’s investments should invest in the Stock
    mutual fund since the maximum of the maximum expected rate of return is the highest for that.
    c) What decision should be made according to the maximin decision rule?

    Investment: Good Average Poor Min


    Stock 16.0% 9.0% -2.0% -2%
    CD 8.0% 8.0% 8.0% 8%

    According to the Maximin decision rule, Philip Mahn’s investments should invest in the
    certificate of deposit, CD, since the maximum of the minimum expected rate of return is the
    highest for that.
    d) What decision should be made according to the minimax regret decision rule?
    Regret Matrix:

    Investment: Good Average Poor Maximum


    Stock 0.0% 0.0% 10.0% 10%
    CD 8.0% 1.0% 0.0% 8%
    The minimum of the maximum regrets is 8% which suggests that Philip Mahn’s investments
    should invest in the certificate of deposit, CD.
    e) What decision should be made according to the EMV decision rule?

    Investment: Good Average Poor EMV


    Stock 16.0% 9.0% -2.0% 9.2%
    CD 8.0% 8.0% 8.0% 8.0%

    Since the EMV is the highest for Stock mutual fund, the Philip Mahn’s investments should invest
    in the stock mutual fund.
    f) What decision should be made according to the EOL decision rule?
    Regret Matrix

    Investment: Good Average Poor EOL


    Stock 0.0% 0.0% 10.0% 0.5%
    CD 8.0% 1.0% 0.0% 1.7%

    The Philip Mahn’s investments should invest in the stock mutual fund since the expected
    opportunity loss, EOL is the lowest for that.

    g) How much should Philip be willing to pay to obtain a market forecast that is 100% accurate?
    The EVoPI is 0.5% as calculated in excel. Philip will be willing to pay $150 to obtain a market
    forecast that is 100% accurate.

    QUESTION #2:

    MicroProducts, Inc., (MPI) manufactures printed circuit boards for a major PC manufacturer. Before a
    board is sent to the customer, three key components must be tested. These components can be
    tested in any order. If any of the components fail, the entire board must be scrapped. The costs of the
    testing the three components are provided in the following table, along with the probability of each
    component failing the test:

    Correction: .14, not .014

    a) Create a decision tree for this problem that could be used to determine the order in which the
    components should be tested to minimize the expected cost of the performing the test.

    Page | 1
    b) In which order should the components be tested?
    Since the monetary value are given in costs of testing, it is appropriate to choose the lowest
    EMV of all three. The lowest EMV is for the order of components X – Z – Y
    c) What is the expected cost of performing the tests in this sequence?
    The expected cost of performing the tests in this sequence is $5.445

    QUESTION #3:

    Southern Gas Company (SGC) is preparing to make a bid for oil and gas leasing rights in a newly
    opened drilling area in the Gulf of Mexico. SGC is trying to decide whether to place a high bid of $16
    million or a low bid of $7 million. SGC expects to be bidding against its major competitor, Northern
    Gas Company (NGC) and predicts NGC to place a bid of $10 million with the probability 0.4 or a bid of
    $6 million with a probability of 0.6. Geological data collected at the drilling site indicates a 0.15
    Page | 2
    probability of the reserves at the site being large, a 0.35 probability of being average, and a .50
    probability of being unusable. A large or average reserve would most likely represent a net asset
    value of $120 million or $28 million, respectively, after all drilling and extracting costs are paid. The
    company that wins the bid will drill an exploration well at the site for a cost of $5 million.

    a) Develop a decision tree for this problem.

    b) What is the optimal decision according to the EMV criterion?


    According to the option set available, all options available for the SGC have equal payoffs. So,
    the SGC can choose any of the available option.

    QUESTION # 4:

    The Mobile Oil company has recently acquired oil rights to a new potential source of natural oil in
    Alaska. The current market value of these rights is $90,000. If there is natural oil on the site, it is
    estimated to be worth $800,000; however, the company would have to pay $100,000 in drilling costs
    to extract the oil. The company believes there is a 0.25 probability that the proposed drilling site
    would actually hit the natural oil reserve. Alternatively, the company can pay $30,000 to first carry out
    a seismic survey at the proposed drilling site. The probability of a favorable seismic survey when oil is
    present at the drilling site is 0.6. The probability of an unfavorable seismic survey when no oil is
    present is 0.80.

    Page | 3
    a) What is the probability of a favorable seismic survey?

    The probability of a favorable seismic survey is calculated as;

    P(favorable survey) = P(favorable survey when oil is present)*P(there is oil) + P(unfavorable


    survey when there is oil)*P(no oil)

    P(Favorable survey) = 0.6(0.25) + 0.2(0.75)

    P(Favorable survey) = 0.3

    b) What is the probability of an unfavorable seismic survey?


    The probability of an unfavorable seismic survey is calculated as;
    P(unfavorable survey) = P(favorable survey when no oil)*P(there is oil) + P(unfavorable survey
    when there is no oil)*P(no oil)
    P(Favorable survey) = 0.4(0.25) + 0.8(0.75)
    P(Favorable survey) = 0.7
    c) Construct a decision tree for this problem

    Page | 4
    d) What is the optimal decision strategy using the EMV criterion?
    The optimal decision strategy for Mobile oil company using the EMV criterion is to do geological
    survey.
    e) To which financial estimate in the decision tree is the EMV most sensitive?
    The EMV is the most sensitive to drilling cost.

    QUESTION # 5:

    Thom DeBusk, an architect, is considering buying, restoring, and reselling a home in the Draper-
    Preston historic district of Blacksburg, Virginia. The cost of the home is $240,000 and Thom believes it
    can be sold for $450,000 after being restored. Thom expects to pay $1,500 a month in finance charges
    from the time he purchases the house until it is sold. Thom has developed two sets of plans for the
    restoration. Plan A will cost $125,000 and require three months to complete. This plan does not
    require changes to the front of the house. Plan B is expected to cost $85,000 and requires 4 months of
    work. This plan does involve changes to the front of the house - which will require the approval of the
    town’s historic preservation committee. Thom expects the approval process for plan B to take two
    months and cost about $5,000. Thom thinks there is a 40% chance the historic preservation committee
    will approve the design. Thom plans to buy the home immediately but cannot decide what he should
    do next. He could immediately proceed with restoration plan A or he could start immediately with
    restoration plan B. Of course, if he starts immediately with plan B, he will not know for two months
    whether the historic preservation committee approves of his plan. If they do not approve it, he will
    have to start over and implement plan A instead. Starting over with plan A would cost and additional
    $20,000 over plan A’s normal cost and add an additional month to plan A’s normal completion
    schedule. Alternatively, Thom can hold off implementing either plan until he knows the outcome of
    the historic planning committee’s decision.

    a) Create a decision tree for this problem.

    Page | 5
    b) What set of decisions should Thom make if he follows the maximum EMV criterion?
    Thom should choose to implement Plan A without applying for approval in change of design.
    Since the cost/EMV for Plan A is the lowest, Thom should execute Plan A for renovation of the
    house.

    Page | 6

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