Chapter 4—Decision Analysis
MULTIPLE CHOICE
1. The options from which a decision maker chooses a course of action are
a. called the decision alternatives.
b. under the control of the decision maker.
c. not the same as the states of nature.
d. All of the alternatives are true.
ANS: D PTS: 1 TOP: Structuring the decision problem
2. States of nature
a. can describe uncontrollable natural events such as floods or freezing temperatures.
b. can be selected by the decision maker.
c. cannot be enumerated by the decision maker.
d. All of the alternatives are true.
ANS: A PTS: 1 TOP: Structuring the decision problem
3. A payoff
a. is always measured in profit.
b. is always measured in cost.
c. exists for each pair of decision alternative and state of nature.
d. exists for each state of nature.
ANS: C PTS: 1 TOP: Payoff tables
4. Making a good decision
a. requires probabilities for all states of nature.
b. requires a clear understanding of decision alternatives, states of nature, and payoffs.
c. implies that a desirable outcome will occur.
d. All of the alternatives are true.
ANS: B PTS: 1 TOP: Decision making without probabilities
5. A decision tree
a. presents all decision alternatives first and follows them with all states of nature.
b. presents all states of nature first and follows them with all decision alternatives.
c. alternates the decision alternatives and states of nature.
d. arranges decision alternatives and states of nature in their natural chronological order.
ANS: D PTS: 1 TOP: Decision trees
6. Which of the methods for decision making without probabilities best protects the decision maker from
undesirable results?
a. the optimistic approach
b. the conservative approach
c. minimum regret
d. minimax regret
ANS: B PTS: 1 TOP: Conservative approach
7. Sensitivity analysis considers
a. how sensitive the decision maker is to risk.
b. changes in the number of states of nature.
c. changes in the values of the payoffs.
d. changes in the available alternatives.
ANS: C PTS: 1 TOP: Sensitivity analysis
8. To find the EVSI,
a. use the EVPI to calculate sample information probabilities.
b. use indicator probabilities to calculate prior probabilities.
c. use prior and sample information probabilities to calculate revised probabilities.
d. use sample information to revise the sample information probabilities.
ANS: C PTS: 1 TOP: Expected value of sample information
9. If P(high) = .3, P(low) = .7, P(favorable | high) = .9, and P(unfavorable | low) = .6, then P(favorable) =
a. .10
b. .27
c. .30
d. .55
ANS: D PTS: 1 TOP: Conditional probability
10. The efficiency of sample information is
a. EVSI*(100%)
b. EVSI/EVPI*(100%)
c. EVwoSI/EVwoPI*(100%)
d. EVwSI/EVwoSI*(100%)
ANS: B PTS: 1 TOP: Efficiency of sample information
11. Decision tree probabilities refer to
a. the probability of finding the optimal strategy
b. the probability of the decision being made
c. the probability of overlooked choices
d. the probability of an uncertain event occurring
ANS: D PTS: 1 TOP: Decision trees
12. For a maximization problem, the conservative approach is often referred to as the
a. minimax approach
b. maximum approach
c. maximax approach
d. minimin approach
ANS: B PTS: 1 TOP: Decision making without probabilities
13. For a minimization problem, the optimistic approach is often referred to as the
a. minimax approach
b. maximin approach
c. maximax approach
d. minimin approach
ANS: D PTS: 1 TOP: Decision making without probabilities
14. For a maximization problem, the optimistic approach is often referred to as the
a. minimax approach
b. maximin approach
c. maximax approach
d. minimin approach
ANS: C PTS: 1 TOP: Decision making without probabilities
15. For a minimization problem, the conservative approach is often referred to as the
a. minimax approach
b. maximin approach
c. maximax approach
d. minimin approach
ANS: A PTS: 1 TOP: Decision making without probabilities
16. Decision tree probabilities refer to the probability of
a. an uncertain event occurring
b. the decision being made
c. finding an optimal value
d. overlooked choices
ANS: A PTS: 1 TOP: Decision making with probabilities
17. Which of the following is NOT an advantage of using decision tree analysis?
a. the ability to see clearly what decisions must be made
b. the ability to see clearly in what sequence the decisions must occur
c. the ability to see clearly the interdependence of decisions
d. the ability to see clearly the future outcome of a decision
ANS: D PTS: 1 TOP: Decision making with probabilities
18. A decision tree provides:
a. a heuristic method for analyzing decisions
b. a deterministic approach to decision analysis
c. the absolute value of the decision
d. an objective way of determining the relative value of each decision alternative
ANS: D PTS: 1 TOP: Decision trees
19. The approach to determine the optimal decision strategy involves
a. a forward (left to right) pass through the decision tree
b. a backward (right to left) pass through the decision tree
c. choosing the outcome of a chance event with the greatest probability
d. choosing the outcome of a chance event with the greatest payoff
ANS: B PTS: 1 TOP: Decision strategy
20. The difference between the expected value of an optimal strategy based on sample information and the
"best" expected value without any sample information is called the
a. information sensitivity
b. expected value of sample information
c. expected value of perfect information
d. efficiency of sample information
ANS: B PTS: 1 TOP: Expected value of sample information
TRUE/FALSE
1. Sample information with an efficiency rating of 100% is perfect information.
ANS: T PTS: 1 TOP: Efficiency of sample information
2. States of nature should be defined so that one and only one will actually occur.
ANS: T PTS: 1 TOP: Structuring the decision process
3. Decision alternatives are structured so that several could occur simultaneously.
ANS: F PTS: 1 TOP: Structuring the decision problem
4. Square nodes in a decision tree indicate that a decision must be made.
ANS: T PTS: 1 TOP: Decision trees
5. Circular nodes in a decision tree indicate that it would be incorrect to choose a path from the node.
ANS: T PTS: 1 TOP: Decision trees
6. Risk analysis helps the decision maker recognize the difference between the expected value of a
decision alternative and the payoff that may actually occur.
ANS: T PTS: 1 TOP: Risk analysis
7. The expected value of an alternative can never be negative.
ANS: F PTS: 1 TOP: Decision making with probabilities
8. Expected value is the sum of the weighted payoff possibilities at a circular node in a decision tree.
ANS: T PTS: 1 TOP: Decision making with probabilities
9. EVPI is always greater than or equal to EVSI.
ANS: T PTS: 1 TOP: Expected value of sample information
10. After all probabilities and payoffs are placed on a decision tree, the decision maker calculates expected
values at state of nature nodes and makes selections at decision nodes.
ANS: T PTS: 1 TOP: Developing a decision strategy
11. A decision strategy is a sequence of decisions and chance outcomes, where the decisions chosen
depend on the yet to be determined outcomes of chance events.
ANS: T PTS: 1 TOP: Decision strategy
12. EVPI equals the expected regret associated with the minimax decision.
ANS: T PTS: 1 TOP: Minimax regret approach
13. The expected value approach is more appropriate for a one-time decision than a repetitive decision.
ANS: F PTS: 1 TOP: Decision making with probabilities
14. Maximizing the expected payoff and minimizing the expected opportunity loss result in the same
recommended decision.
ANS: T PTS: 1 TOP: Minimax regret approach
15. The expected value of sample information can never be less than the expected value of perfect
information.
ANS: F PTS: 1 TOP: Expected value of sample information
16. Pruning a branch of a decision tree occurs at chance events.
ANS: F PTS: 1 TOP: Decision making with probabilities
17. Decision trees are appropriate for multiphase decisions in an environment of certainty.
ANS: F PTS: 1 TOP: Decision trees
18. The primary value of decision trees is as a useful way of organizing how operations managers think
about complex multiphase decisions.
ANS: T PTS: 1 TOP: Decision trees
19. A high efficiency rating indicates that the sample information is almost as good as perfect information.
ANS: T PTS: 1 TOP: Efficiency of sample information
20. When the expected value approach is used to select a decision alternative, the payoff that actually
occurs will usually have a value different from the expected value.
ANS: T PTS: 1 TOP: Decision making with probabilities
SHORT ANSWER
1. Explain why the decision maker might feel uncomfortable with the expected value approach, and
decide to use a non-probabilistic approach even when probabilities are available.
ANS:
Answer not provided.
PTS: 1 TOP: Decision making with probabilities
2. Why perform sensitivity analysis? Of what use is sensitivity analysis where good probability estimates
are difficult to obtain?
ANS:
Answer not provided.
PTS: 1 TOP: Sensitivity analysis
3. How can a good decision maker "improve" luck?
ANS:
Answer not provided.
PTS: 1 TOP: Introduction
4. Use a diagram to compare EVwPI, EVwoPI, EVPI, EVwSI, EVwoSI, and EVSI.
ANS:
Answer not provided.
PTS: 1 TOP: Expected value of sample information
5. Show how you would design a spreadsheet to calculate revised probabilities for two states of nature
and two indicators.
ANS:
Answer not provided.
PTS: 1 TOP: Decision analysis and spreadsheets
6. Characterize each of the non-probabilistic approaches to decision making (i.e. - minimin, minimax,
maximin, and maximax) in terms of it relating to a minimization or maximization problem and
whether it is a pessimistic or optimistic approach.
ANS:
Answer not provided.
PTS: 1 TOP: Decision making without probabilities
PROBLEM
1. Jim has been employed at Gold Key Realty at a salary of $2,000 per month during the past year.
Because Jim is considered to be a top salesman, the manager of Gold Key is offering him one of three
salary plans for the next year: (1) a 25% raise to $2,500 per month; (2) a base salary of $1,000 plus
$600 per house sold; or, (3) a straight commission of $1,000 per house sold. Over the past year, Jim
has sold up to 6 homes in a month.
a. Compute the monthly salary payoff table for Jim.
b. For this payoff table find Jim's optimal decision using: (1) the conservative approach, (2)
minimax regret approach.
c. Suppose that during the past year the following is Jim's distribution of home sales. If one
assumes that this a typical distribution for Jim's monthly sales, which salary plan should
Jim select?
Home Sales Number of Months
0 1
1 2
2 1
3 2
4 1
5 3
6 2
ANS:
a. There are three decision alternatives (salary plans) and seven states of nature (the number
of houses sold monthly).
PAYOFF TABLE Number of Homes Sold
0 1 2 3 4 5 6
Salary Plan I 2500 2500 2500 2500 2500 2500 2500
Salary Plan II 1000 1600 2200 2800 3400 4000 4600
Salary Plan III 0 1000 2000 3000 4000 5000 6000
b. (1) Conservative Approach (Maximin): Plan I
REGRET TABLE Number of Homes Sold
0 1 2 3 4 5 6
Salary Plan I 0 0 0 500 1500 2500 3500
Salary Plan II 1500 900 300 200 600 1000 1400
Salary Plan III 2500 1500 500 0 0 0 0
(2) Minimax Regret Approach: Plan II
c. Use the relative frequency method for determining the probabilities.
Using the EV approach: EV(Plan I) = 2500, EV(Plan II) = 3050, EV(Plan III) = 3417;
Choose Plan III.
PTS: 1 TOP: Decision making with and without probabilities
2. East West Distributing is in the process of trying to determine where they should schedule next year's
production of a popular line of kitchen utensils that they distribute. Manufacturers in four different
countries have submitted bids to East West. However, a pending trade bill in Congress will greatly
affect the cost to East West due to proposed tariffs, favorable trading status, etc.
After careful analysis, East West has determined the following cost breakdown for the four
manufacturers (in $1,000's) based on whether or not the trade bill passes:
Bill Passes Bill Fails
Country A 260 210
Country B 320 160
Country C 240 240
Country D 275 210
a. If East West estimates that there is a 40% chance of the bill passing, which country should
they choose for manufacturing?
b. Over what range of values for the "bill passing" will the solution in part (a) remain
optimal?
ANS:
a. Using EV approach: EV(A) = 230, EV(B) = 224, EV(C) = 240; Choose Country B (lowest
EV)
b. As long as the probability of the bill passing is less than .455, East West should choose
Country B.
PTS: 1 TOP: Decision making with probabilities
3. Transrail is bidding on a project that it figures will cost $400,000 to perform. Using a 25% markup, it
will charge $500,000, netting a profit of $100,000. However, it has been learned that another company,
Rail Freight, is also considering bidding on the project. If Rail Freight does submit a bid, it figures to
be a bid of about $470,000. Transrail really wants this project and is considering a bid with only a 15%
markup to $460,000 to ensure winning regardless of whether or not Rail Freight submits a bid.
a. Prepare a profit payoff table from Transrail's point of view.
b. What decision would be made if Transrail were conservative?
c. If Rail Freight is known to submit bids on only 25% of the projects it considers, what
decision should Transrail make?
d. Given the information in (c), how much would a corporate spy be worth to Transrail to
find out if Rail Freight will bid?
ANS:
a. Rail Freight
Transrail Bid $470,000 Doesn't Bid
Bid $500,000 $0 $100,000
Bid $460,000 $60,000 $ 60,000
b. Bid $460,000
c. Bid $500,000
d. $15,000
PTS: 1 TOP: Decision making with and without probabilities
4. The Super Cola Company must decide whether or not to introduce a new diet soft drink. Management
feels that if it does introduce the diet soda it will yield a profit of $1 million if sales are around 100
million, a profit of $200,000 if sales are around 50 million, or it will lose $2 million if sales are only
around 1 million bottles. If Super Cola does not market the new diet soda, it will suffer a loss of
$400,000.
a. Construct a payoff table for this problem.
b. Construct a regret table for this problem.
c. Should Super Cola introduce the soda if the company: (1) is conservative; (2) is
optimistic; (3) wants to minimize its maximum disappointment?
d. An internal marketing research study has found P(100 million in sales) = 1/3; P(50
million in sales) = 1/2; P(1 million in sales) = 1/6. Should Super Cola introduce the new
diet soda?
e. A consulting firm can perform a more thorough study for $275,000. Should management
have this study performed?
ANS:
a. PAYOFF TABLE Sales ($millions)
100 50 1
Introduce $1,000,000 $200,000 $2,000,000
Do Not Introduce $400,000 $400,000 $400,000
b. REGRET TABLE Sales ($millions)
100 50 1
Introduce $0 $0 $1,600,000
Do Not Introduce $1,400,000 $600,000 $0
c. (1) do not introduce; (2) introduce; (3) do not introduce
d. Yes
e. No
PTS: 1 TOP: Decision making with and without probabilities
5. Super Cola is also considering the introduction of a root beer drink. The company feels that the
probability that the product will be a success is .6. The payoff table is as follows:
Success (s1) Failure (s2)
Produce (d1) $250,000 $300,000
Do Not Produce (d2) $ 50,000 $ 20,000
The company has a choice of two research firms to obtain information for this product. Stanton
Marketing has market indicators, I1 and I2 for which P(I1 | s1) = .7 and P(I1 | s2) = .4. New World
Marketing has indicators J1 and J2 for which P(J1 | s1) = .6 and P(J1 | s2) = .3.
a. What is the optimal decision if neither firm is used? Over what probability of success
range is this decision optimal?
b. What is the EVPI?
c. Find the EVSIs and efficiencies for Stanton and New World.
d. If both firms charge $5,000, which firm should be hired?
e. If Stanton charges $10,000 and New World charges $4,000, which firm should Super Cola
hire? Why?
ANS:
a. Introduce root beer; p .483
b. EVPI = $112,000
NOTE: The answers to (c)-(e) are very sensitive to roundoff error.
Figures in parentheses are for two decimal places only.
c. Stanton: EVSI = $13,200 ($11,862)
Efficiency = .118 (.106)
New World: EVSI = $6,400 ($6,424)
Efficiency = .057 (.057)
d. Hire Stanton (Stanton)
e. Hire New World (Stanton)
PTS: 1 TOP: Computing branch probabilities
6. Dollar Department Stores has just acquired the chain of Wenthrope and Sons Custom Jewelers. Dollar
has received an offer from Harris Diamonds to purchase the Wenthrope store on Grove Street for
$120,000. Dollar has determined probability estimates of the store's future profitability, based on
economic outcomes, as: P($80,000) = .2, P($100,000) = .3, P($120,000) = .1, and P($140,000) = .4.
a. Should Dollar sell the store on Grove Street?
b. What is the EVPI?
c. Dollar can have an economic forecast performed, costing $10,000, that produces
indicators I1 and I2, for which P(I1 | 80,000) = .1; P(I1 | 100,000) = .2; P(I1 | 120,000) = .6;
P(I1 | 140,000) = .3. Should Dollar purchase the forecast?
ANS:
a. Yes, Dollar should sell store
b. EVPI = $8,000
c. No; survey cost exceeds EVPI
PTS: 1 TOP: Computing branch probabilities
7. An appliance dealer must decide how many (if any) new microwave ovens to order for next month.
The ovens cost $220 and sell for $300. Because the oven company is coming out with a new product
line in two months, any ovens not sold next month will have to be sold at the dealer's half price
clearance sale. Additionally, the appliance dealer feels he suffers a loss of $25 for every oven
demanded when he is out of stock. On the basis of past months' sales data, the dealer estimates the
probabilities of monthly demand (D) for 0, 1, 2, or 3 ovens to be .3, .4, .2, and .1, respectively.
The dealer is considering conducting a telephone survey on the customers' attitudes towards
microwave ovens. The results of the survey will either be favorable (F), unfavorable (U) or no opinion
(N). The dealer's probability estimates for the survey results based on the number of units demanded
are:
P(F | D = 0) = .1 P(F | D = 2) .3 P(U | D = 0) = .8 P(U | D = 2) = .1
P(F | D = 1) = .2 P(F | D = 3) .9 P(U | D = 1) = .3 P(U | D = 3) = .1
a. What is the dealer's optimal decision without conducting the survey?
b. What is the EVPI?
c. Based on the survey results what is the optimal decision strategy for the dealer?
d. What is the maximum amount he should pay for this survey?
ANS:
Demand For Ovens
Ovens Ordered 0 1 2 3
0 0 25 50 75
1 70 80 55 30
2 140 10 160 135
3 210 60 90 240
a. Order one oven: EV = $25.00
b. EVPI = $63.00
c. Favorable: order 2; Unfavorable: order 0; No opinion: order 1
d. EVSI = $9.10
PTS: 1 TOP: Computing branch probabilities
8. Lakewood Fashions must decide how many lots of assorted ski wear to order for its three stores.
Information on pricing, sales, and inventory costs has led to the following payoff table, in thousands.
Demand
Order Size Low Medium High
1 lot 12 15 15
2 lots 9 25 35
3 lots 6 35 60
a. What decision should be made by the optimist?
b. What decision should be made by the conservative?
c. What decision should be made using minimax regret?
ANS:
a. 3 lots
b. 1 lot
c. 3 lots
Regret table:
Order Demand Maximum
Size Low Medium High Regret
1 lot 0 20 45 45
2 lots 3 10 25 25
3 lots 6 0 0 6
PTS: 1 TOP: Decision making without probabilities
9. The table shows both prospective profits and losses for a company, depending on what decision is
made and what state of nature occurs. Use the information to determine what the company should do.
State of Nature
Decision s1 s2 s3
d1 30 80 30
d2 100 30 40
d3 80 10 120
d4 20 20 20
a. if an optimistic strategy is used.
b. if a conservative strategy is used.
c. if minimax regret is the strategy.
ANS:
a. d3
b. d1
c. d4
Regret table:
State of Nature Maximum
Decision s1 s2 s3 Regret
d1 70 0 150 150
d2 0 50 160 160
d3 180 90 0 180
d4 80 60 100 100
PTS: 1 TOP: Decision making without probabilities
10. A payoff table is given as
State of Nature
Decision s1 s2 s3
d1 10 8 6
d2 14 15 2
d3 7 8 9
a. What decision should be made by the optimistic decision maker?
b. What decision should be made by the conservative decision maker?
c. What decision should be made under minimax regret?
d. If the probabilities of s1, s2, and s3 are .2, .4, and .4, respectively, then what decision should
be made under expected value?
e. What is the EVPI?
ANS:
a. d2
b. d3
c. a three way tie
d. EV(d1) = 7.6
EV(d2) = 9.6 (the best)
EV(d3) = 8.2
e. EVPI = 12.4 9.6 = 2.8
PTS: 1 TOP: Decision making with and without probabilities
11. A payoff table is given as
State of Nature
Decision s1 s2 s3
d1 250 750 500
d2 300 250 1200
d3 500 500 600
a. What choice should be made by the optimistic decision maker?
b. What choice should be made by the conservative decision maker?
c. What decision should be made under minimax regret?
d. If the probabilities of d1, d2, and d3 are .2, .5, and .3, respectively, then what choice should
be made under expected value?
e. What is the EVPI?
ANS:
a. d2
b. d3
c. d1
d. EV(d1) = 695 (the best)
EV(d2) = 385
EV(d 3) = 500
e. EVPI = 925 695 = 230
PTS: 1 TOP: Decision making with and without probabilities
12. A decision maker has developed the following decision tree. How sensitive is the choice between N
and P to the probabilities of states of nature U and V?
ANS:
Choose N if p .78.
PTS: 1 TOP: Sensitivity analysis
13. If p is the probability of Event 1 and (1 p) is the probability of Event 2, for what values of p would
you choose A? B? C? Values in the table are payoffs.
Choice/Event Event 1 Event 2
A 0 20
B 4 16
C 8 0
ANS:
Choose A if p .5, choose B is .5 p .8, and choose C if p .8.
PTS: 1 TOP: Sensitivity analysis
14. Fold back the decision tree and state what strategy should be followed.
ANS:
Strategy: Select A. If C happens, select H. If D happens, you are done. If E happens, select K.
PTS: 1 TOP: Expected value and decision trees
15. Fold back this decision tree. Clearly state the decision strategy you determine.
ANS:
Choose A. If F happens, choose K.
PTS: 1 TOP: Expected value and decision trees
16. If sample information is obtained, the result of the sample information will be either positive or
negative. No matter which result occurs, the choice to select option A or option B exists. And no matter
which option is chosen, the eventual outcome will be good or poor. Complete the table.
Sample States of Prior Conditional Joint Posterior
Result Nature Probabilities Probabilities Probabilities Probabilities
Positive good .7 P(positive | good) = .8
poor .3 P(positive | poor) = .1
Negative good .7 P(negative | good) =
poor .3 P(negative | poor) =
ANS:
Sample States of Prior Conditional Joint Posterior
Result Nature Probabilities Probabilities Probabilities Probabilities
Positive good .7 P(positive | good) = .8 .56 .9492
poor .3 P(positive | poor) = .1 .03 .0508
Negative good .7 P(negative | good) = .2 .14 .3415
poor .3 P(negative | poor) = .9 .27 .6585
PTS: 1 TOP: Posterior probabilities
17. Use graphical sensitivity analysis to determine the range of values of the probability of state of nature
s1 over which each of the decision alternatives has its largest expected value.
State of Nature
Decision s1 s2
d1 8 10
d2 4 16
d3 10 0
ANS:
EV(d1) and EV(d2) intersect at p = .6. EV(d1) and EV(d3) intersect at p = .8333. Therefore when 0 p
.6, choose d2. When .6 p .8333, choose d1. When p .8333, choose d3.
PTS: 1 TOP: Graphical sensitivity analysis
18. A manufacturing company is considering expanding its production capacity to meet a growing demand
for its product line of air fresheners. The alternatives are to build a new plant, expand the old plant, or
do nothing. The marketing department estimates a 35 percent probability of a market upturn, a 40
percent probability of a stable market, and a 25 percent probability of a market downturn. Georgia
Swain, the firm's capital appropriations analyst, estimates the following annual returns for these
alternatives:
Market Stable Market
Upturn Market Downturn
Build new plant $690,000 $(130,000) $(150,000)
Expand old plant 490,000 (45,000) (65,000)
Do nothing 50,000 0 (20,000)
a. Use a decision tree analysis to analyze these decision alternatives.
b. What should the company do?
c. What returns will accrue to the company if your recommendation is followed?
ANS:
a. Decision tree:
b. Decision: Build the new plant
c. Returns to accrue: $690,000; ($130,000); or ($150,000)
PTS: 1
19. The Sunshine Manufacturing Company has developed a unique new product and must now decide
between two facility plans. The first alternative is to build a large new facility immediately. The
second alternative is to build a small plant initially and to consider expanding it to a larger facility
three years later if the market has proven favorable.
Marketing has provided the following probability estimates for a ten-year plan:
First 3-Year Demand Next 7-Year Demand Probability
Unfavorable Unfavorable .2
Unfavorable Favorable .0
Favorable Favorable .7
Favorable Unfavorable .1
If the small plant is expanded, the probability of demands over the remaining seven years is 7/8 for
favorable and 1/8 for unfavorable. The accounting department has provided the payoff for each
outcome:
Demand Facility Plan Payoff
Favorable, favorable 1 $5,000,000
Favorable, unfavorable 1 2,500,000
Unfavorable, unfavorable 1 1,000,000
Favorable, favorable 2--expanded 4,000,000
Favorable, unfavorable 2--expanded 100,000
Favorable, favorable 2--not expanded 1,500,000
Favorable, unfavorable 2--not expanded 500,000
Unfavorable, unfavorable 2--not expanded 300,000
With these estimates, analyze Sunshine's facility decision and:
a. Perform a complete decision tree analysis.
b. Recommend a strategy to Sunshine.
c. Determine what payoffs will result from your recommendation.
ANS:
a. Decision tree:
b. Recommended strategy: Build the large plant
c. Possible payoffs that will result: $5,000,000; $2,500,000; or $1,000,000
PTS: 1
20. A Pacific Northwest lumber company is considering the expansion of one of its mills. The question is
whether to do it now, or wait for one year and re-consider. If they expand now, the major factors of
importance are the state of the economy and the level of interest rates. The combination of these two
factors results in five possible situations. If they do not expand now, only the state of the economy is
important and three conditions characterize the possibilities. The following table summarizes the
situation:
Probabilities Revenues
Expand
very favorable .2 $80,000
favorable .2 $60,000
neutral .1 $20,000
unfavorable .3 -$20,000
very unfavorable .2 -$30,000
Don't expand
expansion .2 $50,000
steady .5 $30,000
contraction .3 $10,000
a. Draw the decision tree for this problem.
b. What is the expected value for expanding?
c. What is the expected value for not expanding?
d. Based on expected value, what should the company’s decision(s) be?
ANS:
a.
b. EV(Expanding) = 2(80,000) + .2(60,000) + .1(20,000)
+ .3(-20,000) + .2(-30,000) = $18,000
c. EV(Not Expanding) = 2(50,000) + .5(30,000) + .3(10,000) = $28,000
d. Do not expand.
PTS: 1
