DECISION 521 – Decision Analytics & Modeling
Fuqua School of Business
Spring Term 1, 2024
Value of Information Exercises
Prepare for Class 3
Assignment: Answer the questions on the following pages.
Deliverables:
• Submit an electronic copy of your Excel model(s) on Canvas. We may open some of your
Excel models in class or review them outside of class.
• Please note your name, section number, and whom, if anyone, you worked with on this
assignment.
In your submissions, be sure to highlight your answers to the questions asked, e.g., by circling
them and labeling them (1a, 1b, etc.).
You may work in groups to discuss the assignment, but each student should submit their work
individually and should be prepared to explain the work submitted.
1. Industrial Espionage. Suppose you are a network systems provider and are bidding for the
job of providing and installing a system for a new government office building. You are
considering submitting one of three bids: a low bid of $500,000, a medium bid of $600,000, and
a high bid of $700,000. The cost of the job to you will be $450,000, regardless of your bid. Thus,
if you submit a bid of $500,000 and win the contract, your profit will be $500,000 − $450,000 =
$50,000. If you win with a bid of $600,000, your profit will be $150,000. If you do not win the
contract, your profit will be zero.
Two competitors will also submit bids. Each competitor will bid $500,000, $600,000, or
$700,000 with probability 1/3 each, with your competitors' bids being independent of each
other. The contract will be awarded to the lowest bidder. In the case of a tie, the contract will be
awarded to the bidder with the most experience. In this case, you will certainly win because
your company has more experience than the other two. The bids are sealed and made
simultaneously.
(a) If you bid medium ($600,000), what is your probability of winning the contract?
(b) Draw a decision tree to determine which bid (low, medium, high) yields the highest
expected profit for you.
(c) Suppose a clairvoyant could tell you in advance exactly what both competitors’ bids will be.
What is the expected value of this information?
(d) Suppose instead that the clairvoyant could tell you in advance exactly what competitor #1's
bid will be, but you would remain uncertain about competitor #2's bid. What is the expected
value of this information?
2. Oil Drilling – Cobalt Revisited. Cobalt International Energy has identified two attractive
drilling sites off the coast of Angola; they are called Bicuar (Site B) and Cameia (Site C). The two
sites are about 12 miles apart and share some geologic features.
Cameia Bicuar
15,000 ft
beneath
ocean
floor
First, consider site B alone. The estimated drilling cost is $40 million. For simplicity, assume that
if you drill at this site, there are two possible outcomes: either there is oil at the site or there is
no oil. Based on the available data, your geologists assign a 20% chance that there is oil at the
site (the site is "wet"). If there is oil, your geologists believe that the expected present value of a
well in this location is $160 million (not including the drilling cost). If there is no oil (the site is
"dry"), assume that the value of the drilled site is $0.
a) Should you drill at site B?
b) Suppose you could find out definitively whether or not there was oil at this site, before
deciding whether to drill. What is the most you would be willing to pay for this information?
Hint for 2c) and 2d): All relevant probabilities for solving c) and d) are provided by probability
trees in the “trees_Q2cd.xlsx” spreadsheet. However, it is advisable to initially attempt
solving Questions 2c and 2d without referring to the spreadsheet. This approach may provide
a better understanding of the underlying concepts.
c) Instead of obtaining perfect information, in the real world, you can do seismic testing. In this
procedure, one sets off explosives on the ocean floor and measures the seismic waves at
other points on the ocean floor. From the seismic data, one can construct a 3D image of the
subsurface geology and see if there are structures that may form an oil reservoir. Your
geologists estimate that most (90%) of the wet sites have structures that can be detected by
this seismic test. However, many (60%) of the dry sites also have these structures. The
seismic test costs $2.5 million. Do you want to do the test?
d) Now ignore the possibility of doing the seismic test and consider two sites. Like B, site C
costs $40 million to drill and, if C is wet, the expected present value is $160 million;
otherwise, the value of C is $0. The geologists provide the following joint probabilities: 72%
chance both B and C are dry, 13% chance both are wet, 7% chance B is wet but C is dry, and
8% chance B is dry but C is wet. Should you drill one, both, or neither of these sites? What is
the optimal drilling strategy?
