DECISION TREE AND VALUE OF INFORMATION
Scenario: You are deciding among three investments, as you do for Case 4. You
have heard of an expert who has a highly reliable “track record” in the correct
identification of favorable vs. unfavorable market conditions. You are now
considering whether to consult this “expert.” Therefore, you need to determine
whether it would be worth paying the expert’s fee to get his prediction. You recognize
that you need to do further analysis to determine the value of the information that the
expert might provide.
In order to simplify the analysis, you have decided to look at two possible outcomes
for each alternative (instead of three). You are interested in whether the market will
be Favorable or Unfavorable, so you have collapsed the Medium and Low
outcomes. Here are the three alternatives with their respective payoffs and
probabilities.
Option A: Real estate development. This is a risky opportunity with the possibility of
a high payoff, but also with no payoff at all. You have reviewed all of the possible
data for the outcomes in the next 10 years and these are your estimates of the Net
Present Value (NPV) of the payoffs and probabilities:
High/Favorable NPV: $7.5 million, Pr = 0.5
Unfavorable NPV: $2.0 million, Pr = 0.5
Option B: Retail franchise for Just Hats, a boutique-type store selling fashion hats
for men and women. This also is a risky opportunity but less so than Option A. It has
the potential for less risk of failure, but also a lower payoff. You have reviewed all of
the possible data for the outcomes in the next 10 years and these are your estimates
of the NPV of the payoffs and probabilities.
High/Favorable NPV: $4.5 million, Pr = 0.75
Unfavorable NPV: $2.5 million, Pr = 0.25
Option C: High Yield Municipal Bonds. This option has low risk and is assumed to
be a Certainty. So there is only one outcome with probability of 1.0:
NPV: $2.25 million, Pr = 1.0
You have contacted the expert and received a letter stating his track record which
you have checked out using several resources. Here is his stated track record:
2/4
True State of the Market
Expert Prediction Favorable Unfavorable
Predicts “Favorable” .9 .3
Predicts “Unfavorable” .1 .7
You realize that this situation is a bit complicated since it requires the expert to
analyze and predict the state of two different markets: the real estate market and the
retail hat market. You think through the issues of probabilities and how to calculate
the joint probabilities of both markets going up, both going down, or one up and the
other down. Based on your original estimates of success, here are your calculations
of the single probabilities and joint probabilities of the markets.
Probabilities Favorable Unfavorable
A: Real Estate 0.50 0.50
B: Just Hats 0.75 0.25
Joint Probabilities
A Fav, B Fav (A+, B+) 0.375
A Unf, B Unf (A-, B-) 0.125
A Fav, B Unf (A+, B-) 0.125
A Unf, B Fav (A-, B+) 0.375
Finally, after a great deal of analysis and calculation, you have determined the
Posterior probabilities of Favorable and Unfavorable Markets for the Real Estate
business and the boutique hat business.
Real Estate Just Hats
F U F U
0.45 says “F/F” 0.75 0.25 0.90 0.10
0.15
says
“F/U”
0.75 0.25 0.30 0.70
0.30 says 0.125 0.875 0.90 0.10
3/4
“U/F”
0.10
says
“U/U”
0.125 0.875 0.30 0.70
For example, this table says that there is 45% chance that the expert will predict
Favorable for both markets (F/F), and when he makes this prediction, there is a 75%
chance that the Real Estate market will be favorable and 25% chance that it won’t,
and also a 90% chance that the Hat market will be Favorable and 10% chance it
won’t.
You have developed a Decision Tree showing the original collapsed solution and
also showing an expanded Decision Tree for evaluating the value of the expert’s
information. You need to enter the probabilities into this tree to see if the expert’s
information will increase the overall expected value of your decision. Download the
Excel file with the incomplete Decision Tree: Decision Tree for SLP 4
Assignment
Complete the information in the Decision Tree in the Excel file. Determine the
Expected NPV of the decision if you were to consult the Expert. Does use of the
Expert increase the value of your analysis? If so, by how much?
Develop a PowerPoint presentation to your private investment company and explain
your analysis and your recommendation. Provide clear rationale/ justification for your
decision. Use audio/video feature in PowerPoint to present each slide. Be sure to
check the Oral Communication Rubric (under Assessments>Rubrics) to understand
the requirements for the PowerPoint presentation.
Upload both your PowerPoint presentation and Excel file with the Decision Tree
analysis to the SLP 4 Dropbox.
SLP Assignment Expectations
Analysis
Conduct accurate and complete analysis in Excel. Check the following link on
PowerPoint presentation:
https://support.office.com/en-US/article/PowerPoint-training-40e8c930-cb0b-40d8-
82c4-bd53d3398787
Required:
Meet Length requirements: 10-15 slides (not including Cover and Reference
pages).
Provide a brief introduction to/background of the problem.
4/4
Show analysis that supports Excel analysis and provides thorough discussion of
assumptions, rationale, and logic used.
Offer meaningful and accurate recommendation(s).
Oral presentation of each slide should use video/audio feature in PowerPoint.
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