"Now let's find Leo, and get to work on his decision problem," Alice says, snapping her laptop shut.
I calculated that if the floating restaurant idea really takes off, I'd make over $2 million in profits over the next five years. And that's after I subtract my initial investment, including the purchase of the ship.
How certain are you that the Tethys will be the success you envision?
Gosh, I don't know. It's almost like a flip of a coin to me — chances are about fifty/fifty that the Tethys will be a big hit.
That sounds a little too optimistic. Let's take a close look at your business plan.
The three of you spend the rest of the day in energetic discussion and research. Finally, you agree on two representative scenarios that might occur if Leo launches the Chez Tethys: "Phenomenon," or "Fad."
If the Tethys becomes a cultural "Phenomenon" with staying power, Leo can expect $2 million in profits over five years, in terms of net present value. Leo grudgingly agrees that the likelihood of this scenario is only 35%.
Alternatively, dining Chez Tethys might become a passing "Fad" for a couple of years, then be replaced by "The Next Big Thing." In that case, Leo would face substantial losses, estimated to have a present value of about $800,000. Leo grants that his brainchild has a 65% chance of just being a fad.
What is the EMV of launching the Chez Tethys?
Enter the EMV in $millions as a decimal number with three digits to the right of the decimal point (e.g., enter ''$5,500,000'' as ''5.500''). Round if necessary.
The expected monetary value of launching the Tethys is the outcome value of the "Phenomenon" scenario weighted by its probability added to the outcome value of the "Fad" scenario weighted by its probability, i.e., $180,000.
Hmm. I can see how this analysis is helpful. I'm glad that my expected profits are positive, but somehow I'm not satisfied. I don't feel very comfortable with some of our estimates.
Exercise 1: The Shipping Bea Flies Again
Robin Bea is the CEO of a small shipping company. She needs to decide whether or not to lease another truck to add to her current fleet.
Robin identifies three states of the transportation sector that might occur: "Boom," "Moderate Growth," and
"Slowdown,". Her firms profits depend on whether she leases an additional truck and on the state of the sector:
She associates an estimate of total firm profits with each of the six scenarios.
What is the EMV of the decision to lease the truck?
Enter the EMV in $thousands as a decimal number with one digit to the right of the decimal point (e.g., enter ''$5,500'' as ''5.5''). Round if necessary.
The EMV of the decision to lease the truck is $31,000. Weight each of the scenario's outcomes by the probabilities that they will occur, then add the weighted values.
What is the EMV of the decision to not lease the truck?
Enter the EMV in $thousands as a decimal number with one digit to the right of the decimal point (e.g., enter ''$5,500'' as ''5.5''). Round if necessary.
The EMV of the option to not lease the truck is $18,200. Weight each of the scenario's outcomes by the probabilities that they will occur, then add the weighted values.
Exercise 2: The SHAMH of the Century
Jari Lipponen of the Silverhaven Home for Abandoned Miniature Horses (SHAMH) needs funds to maintain operations. He can either apply for a government grant or run a local fundraiser, but the demands on his time are too high for him to be able to do both.
Jari believes he has a 90% chance that he will win a grant of $25,000 if he submits the grant application. Grants in this category are for a fixed amount, so if he loses the grant, he'll have no money to run the SHAMH.
Based on his past fundraising experience, he estimates that if he runs a local fundraiser, he has a 30% chance of raising $30,000 and 70% chance of raising $20,000.
What is the EMV of launching a fundraiser?
Enter the EMV in $thousands as a decimal number with one digit to the right of the decimal point (e.g., enter ''$5,500'' as ''5.5''). Round if necessary.
To find the EMV of launching the fundraiser, weight the $30,000 outcome value by its probability of 30% and add that to the $20,000 outcome value weighted by its probability of 70%.
What is the EMV of applying for the grant?
Enter the EMV in $thousands as a decimal number with one digit to the right of the decimal point (e.g., enter ''$5,500'' as ''5.5''). Round if necessary.
To find the EMV of applying for the grant, weight the grant award amount of $25,000 by the probability of winning it (90%) and add that to the value of losing the reward ($0) weighted by the probability of losing (10%).
The EMV of the fundraiser option is $23,000, higher than the EMV of applying for the grant. Based on thia analysis, Jari should organize a fundraiser.
Exercise 3: The Gaiacorps Upgrade
Marsha Ratulangi is the chief operating officer at Gaiacorps, a nonprofit organization dedicated to preserving natural habitats around the world. Gaiacorps' IT hardware is aging, and Marsha must decide whether to extend the current lease on Gaiacorps' IT desktop computers or purchase new ones.
Which of the following costs is not relevant to Marsha's decision?
The cost of the lease extension and the future maintenance costs of the current hardware are incurred only in the scenario in which Gaiacorps extends its current lease. The purchase price of the new hardware is incurred only in the scenario in which Gaiacorps purchases new hardware. Which of the three costs are incurred depends on which option Marsha chooses, so all three are highly relevant to her decision.
Which of the following costs is relevant to Marsha's decision?
The cost of the memory card upgrade and the maintenance costs previously invested in the current hardware are sunk costs that have already been incurred.
Marsha's salary is not a sunk cost, but is incurred in all possible scenarios. Neither of the options Marsha is considering will affect the amount of these three costs, thus all three costs are irrelevant to the decision.
In contrast, the cost of disposing of the new hardware is relevant, since it is incurred only in the case that Marsha buys new desktop computers.
Exercise 4: Mopping up the Empire
Under pressure from his company's ad hoc advisory board to lower operating expenses, the CEO of Empire
Learning, Bill Hartborne, is considering canceling the biweekly cleaning service for the company offices. Each cleaning engagement costs $75.
Instead of hiring a cleaning service, Bill could simply clean the office himself whenever a client visits the office.
The probability of exactly one client visiting the office in a given month is 25%, and the probability that two clients will visit is 10%. The probability that no clients will visit is 65%.
Bill draws up the structure of his decision in the tree depicted below. Given a onemonth time horizon, what is your best estimate of the EMV of the cost of not hiring a cleaning service?
Instead of cleaning the office, Bill could be creating value for his company by making sales, networking, boosting employee morale, or simply increasing his productivity by napping on the office sofa. We need to calculate the opportunity cost of the time Bill would spend cleaning the office, so we need to know how long he spends cleaning, and how highly his time is valued.
Assuming that it always takes Bill 2 full hours to clean Empire Learning's offices, and that Bill's time is valued at
$200/hour, what is the EMV of Bill cleaning the office?
Enter the EMV in dollars as an integer (e.g., enter ''$5.00'' as ''5''). Round if necessary.
The EMV of Bill cleaning the office is $180. Based on this analysis, Bill should continue employing the cleaning service.
Exercise 5: The Eris Shoe Company
Val Purcell, CEO of a supplychain management consulting firm Purcell & Co., must decide whether or not to put in a bid for a contract to reengineer the supply chain of a potential new client: the Eris Shoe Company.
Creating the bid will cost $16,000 in Val's time and legal fees. If his bid beats out the competition, Val expects the contract to return profits of $100,000 — from which the cost of preparing the bid has not yet been subtracted. Val believes he has a 20% chance of winning the bid.
Eris will pay the consulting fee and Val will accrue his estimated $100,000 profits upon completion of the project, which is scheduled for one year from now.
Under these terms, what is the expected monetary value of creating and submitting the bid?
The answer cannot be determined without knowing Purcell's discount rate. If Purcell wins the bid, it won't receive its consulting fee until completion of the project one year from now. Cash flows related to the contract should be discounted at Purcell's discount rate. For simplicity assume that the cost/profit figures represent cash outflows and inflows, and that Purcell's discount rate is 15%.
What is the EMV for the option of submitting this bid?
Enter the EMV in $thousands as a decimal number with two digits to the right of the decimal point (e.g., enter ''$5,500'' as ''5.50''). Round if necessary.
To find the EMV of creating the bid, first calculate the present value of the cash inflow from Purcell's profits on the contract, to be received a year from now upon completion of the project.
To determine the net present value of winning the bid, we subtract the $16,000 bid preparation costs.
Then, use the probability of winning the bid to weight the EMVs of the "Win" and "Don't win" scenarios to determine the EMV of placing the bid.
Before Val starts work on the bid, Eris decides to move the project's completion date to two years after the contract is signed. Again assume that the cost/profit figures represent cash outflows and inflows, and that Purcell's
discount rate is 15%. What is the EMV for submitting the bid now?
Enter the EMV in dollars as an integer (e.g., enter ''$5.00'' as ''5''). Round if necessary.
To find the new EMV of putting in the bid, first calculate the present value of the cash inflow from Purcell's profits on the contract, to be received two years from now upon completion of the project.
To determine the net present value of winning the bid, we subtract the $16,000 bid preparation costs.
Then, use the probability of winning the bid to weight the EMVs of the "Win" and "Don't win" scenarios and
determine the EMV of placing the bid. The EMV of putting in the bid is $877. If Val's payments are delayed by another year, he cannot expect the project to be profitable, so he should not submit a bid. Delaying the profits changes Val's optimal decision!
Exercise 6: The Crumbling Empire
Cap Winestone of Universal Learning is preparing a bid for a new building to accommodate its expanding operations. As luck has it, the headquarters of former competitor Empire Learning is for sale through a sealed bid auction. The building is well suited to Universal's needs, containing computing equipment, network infrastructure and other important elearning accessories.
Cap estimates the building is worth about $900,000 to him, and is trying to decide what bid to place. To simplify his decision, he narrows down his bid choices to four possible bids. He muses: "With lower bids I gain more value. If I bid $600,000, I'll get a building worth $900,000 to me, so I gain $300,000 in value. In terms of the value I gain, the lower the bid, the better.
"On the other hand," Cap continues, "With a low bid I'm not likely to win. From the point of view of winning the bid, the higher the bid the better. How do I balance these two opposing factors?
Cap lays out a decision tree with the possible bid amounts, the likelihood of winning for each bid, and the outcome values. What amount should Cap bid?
Folding back the tree, we find the $800,000 bid gives the highest expected monetary value. the $800,000 bid best balances the value gained against the probability of winning.