Risk and Uncertainty … Feb 2020

Risk
Risk exists where a decision maker has knowledge that several possible future outcomes
are possible, usually due to past experience. This past experience enables a decision
maker to estimate the probability of the likely occurrence of each potential future outcome.
Uncertainty
Uncertainty exists when the future is unknown and the decision maker has no past
experience on which to base predictions. Following techniques can be adopted to reduce
• market research • focus groups
Risk preference
(a) Risk seeker – An optimist. A decision maker who is interested in the best outcomes
no matter how small a chance that they may occur.
(b) Risk neutral – A decision maker who is concerned with the most likely outcome.
(c ) Risk averse – A pessimist. A decision maker who acts on the assumption that the
worst outcome might occur.

Ex 1 John must decide how best to use a monthly factory capacity of 1,200 units for a special contract
to sell units @ Rs 9 each. His demand from regular customers is uncertain and as follows:
Monthly demand (Units) Probability
400 0.2
500 0.3
700 0.4
900 0.1

All units cost Rs 6 to make. Selling price to regular customers is Rs 11 per unit.
The company can vary production levels during the month to match demand (up to the
maximum 1,200 units). For the special contract the company must enter a binding
agreement now at a level of either 800, 700, 500 or 300 units.
Required
Display all possible profits in a profit data table.

Expected values (EV)

Where there is uncertainty and a range of possible future outcomes has been quantified
(for example, best, worst and most likely) probabilities can be assigned to these
outcomes and a weighted average (expected value) of those outcomes calculated. EV = Σpx
where p is the probability of the outcome occurring and x is the value of the outcome
(profit or cost) When faced with a number of alternative decisions, the one with the
highest EV should be chosen.

Ex 2 Suppose we assume that in example 1 John wants to maximise profits over the long term.
Find the optimal level of special contract to commit to every month, using expected values.

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 Limitations of expected values
(a) EV is a long-term average, so that the EV will not be reached in the short term and
is therefore not suitable for one-off decisions.
(b) The results are dependent on the accuracy of the probability distribution. In particular,
it uses discrete variables rather than continuous variables (i.e variables are point
estimates rather than a continuous range). This may not accurately model the real
situation.
(c) EV takes no account of the risk associated with a decision.
(d) The EV itself may not represent a single possible outcome.

Maximin decisions Maximise the minimum return of each decision.

Risk averse decision-maker.
Criticisms of maximin • Ignores the probability of each outcome occurring
• Is conservative (doesn’t try to maximise profit)

Maximax decisions Aim for the best possible return.

Risk seeking decision maker.
Criticisms of maximax • Ignores the probability of each outcome occurring
• Is overly optimistic

Minimax regret decision rule

Regret' means opportunity cost from making the wrong decision. The decision rule chooses the
option which minimises the maximum opportunity cost from making the wrong decision.

Two way data table

Purpose
If there are two variables about which a company is concerned when planning, a two way data
table can be prepared (using a spreadsheet model) which will display all possible outcomes.
Analysis
Analysis could take the form of expected values or the data table could be used only to give
management an overview of the decision it is facing.

Ex -3 Browns Ltd manufactures and sells a single product in a competitive market. The unit cost is
Rs 19 but sales price and demand are both uncertain. Co believes that the following could occur;

Price (Rs ) Probability Demand(units) Probability

28 0.2 30,000 0.4
29 0.4 35,000 0.5
30 0.5 40,000 0.1
Brown Ltd has fixed costs of Rs 320,000.

Required
a) Construct a two-way data table for contribution generated.
b) Calculate the expected value of Brown Ltd's contribution.
(c) What is the probability of Brown Ltd at least breaking even?

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 Sensitivity analysis
Assessing probabilities of a range of variables may be difficult with certainty. Sensitivity analysis
permits an alternative way of assessing risk.
Decisions are assessed for their response to a change in a variable.
Approaches to sensitivity analysis are:
(a) calculating the maximum percentage change in a variable before the decision would change.
(b) assessing if the decision would change if a variable changed by x% of estimate.
(c) estimating by how much costs / revenues would need to change before the decision maker
would be indifferent between two options
Limitations of sensitivity analysis
• Only one variable can be tested at a time • There is no decision rule
• It does not quantify the probability of the variable changing

Ex -4 Company P is considering the launch of a new product. With $10 sales price, $2 material
cost and $3 labour cost. Fixed cost are $30,000 and 10,000 units are expected to be sold.
Required
Assess the sensitivity of the product to a change in (a) material cost (b) units sold

Cost of buying Perfect Information

When a decision-maker is faced with a series of uncertain events that might occur, he should
consider the possibility of obtaining additional information about which event is likely to occur.
Here we will consider how we can calculate the maximum amount it would be worth paying
to acquire additional information from a particular source. The approach is to compare the
expected value of a decision if the information is acquired against the expected value with the
absence of the information. The difference represents the maximum amount it is worth paying
for the additional information.

Example
The B Company must choose between one of two machines – machine A has low fixed costs
and high unit variable costs, whereas machine B has high fixed costs and low unit variable
costs. Consequently, machine A is most suited to low-level demand whereas machine B is
suited to high-level demand. For simplicity assume that there are only two possible demand
levels – low and high – and the estimated probability of each of these events is 0.5. The
estimated profits for each demand level are as follows:
Low High Expected
demand demand value
Machine A 500,000 800,000 650,000
Machine B 50,000 1,000,000 525,000

There is a possibility of employing a firm of market consultants who would be able to provide
a perfect prediction of the actual demand. What is the maximum amount the company should
be prepared to pay the consultants for the additional information?

When the decision to employ the market consultants is being taken, it is not known which
level of demand will be predicted. Therefore the best estimate of the outcome from obtaining
the additional information is a 0.5 probability that it will predict a low demand and a 0.5
probability that it will predict a high demand.

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 Rs
Expected value without perfect information higher of 650,000 and 525,000 650,000
Expected value with perfect information 500,000 x 0.5 + 1,000,000 x 0.5 750,000
Cost of perfect information 100,000

In practice, it is unlikely that perfect information is obtainable, but imperfect information

(for example, predictions of future demand may be only 80 per cent reliable) may still be worth
obtaining. However, the value of imperfect information will always be less than the value of
perfect information. The principles that are applied for calculating the value of imperfect
information are the same, but the calculations are more complex

Q.1 Stow Health Centre specialises in the provision of sports/exercise and medical/dietary
advice to clients. The service is provided on a residential basis and clients stay for
whatever number of days suits their needs.
Budgeted estimates for the year ending 31 June 20X1 are as follows.

(a) The maximum capacity of the centre is 50 clients per day for 350 days in the year.

(b) Clients will be invoiced at a fee per day. The budgeted occupancy level will vary with
the client fee level per day and is estimated at different percentages of maximum
capacity as follows.
Client fee Occupancy Occupancy as percentage of
per day level maximum capacity
$180 High 90%
$200 Most likely 75%
$220 Low 60%

(c) Variable costs are also estimated at one of three levels per client day. The high, most
likely and low levels per client day are $95, $85 and $70 respectively.
The range of cost levels reflects only the possible effect of the purchase prices of goods
and services.

Required
(a) Prepare a summary which shows the budgeted contribution earned by Stow Health
Centre for the year ended 30 June 20X1 for each of nine possible outcomes. (7 marks)

(b) State the client fee strategy for the year to 30 June 20X1 which will result from the use
of each of the following decision rules.
(i) Maximax
(ii) Maximin
(iii) Minimax regret (12 marks)

(c) The probabilities of variable cost levels occurring at the high, most likely and low levels
provided in the question are estimated as 0.1, 0.6 and 0.3 respectively.
Using the information available, determine the client fee strategy which will be chosen where
maximisation of expected value of contribution is used as the decision basis. (6 marks)

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Q.2 Shifters Haulage (SH) is considering changing some of the vans it uses to transport
crates for customers. The new vans come in three sizes; small, medium and large.
SH is unsure about which type to buy. The capacity is 100 crates for the small van,
150 for the medium van and 200 for the large van.
Demand for crates varies and can be either 120 or 190 crates per period, with the
probability of the higher demand figure being 0·6.
The sale price per crate is $10 and the variable cost $4 per crate for all van sizes
subject to the fact that if the capacity of the van is greater than the demand for crates
in a period then the variable cost will be lower by 10% to allow for the fact that the vans
will be partly empty when transporting crates.
SH is concerned that if the demand for crates exceeds the capacity of the vans then
customers will have to be turned away. SH estimates that in this case goodwill of $100
would be charged against profits per period to allow for lost future sales regardless of
the number of customers that are turned away.
Depreciation charged would be $200 per period for the small, $300 for the medium
and $400 for the large van.
SH has in the past been very aggressive in its decision-making, pressing ahead with
rapid growth strategies. However, its managers have recently grown more cautious
as the business has become more competitive.
Required:
(a) Explain the principles behind the maximax, maximin and expected value criteria that
are sometimes used to make decisions in uncertain situations. (4 marks)
(b) Prepare a profits table showing the SIX possible profit figures per period. (9 marks)
(c) Using your profit table from (b) above discuss which type of van SH should buy
taking into consideration the possible risk attitudes of the managers. (6 marks)

Q3 A theatre has a seating capacity of 500 people and is considering engaging MS and her
orchestra for a concert for one night only. The fee that would be charged by MS would be
$10,000. If the theatre engages MS, then this sum is payable regardless of the size of the
theatre audience.
Based on past experience of events of this type, the price of the theatre ticket would be $25
per person. The size of the audience for this event is uncertain, but based on past experience
it is expected to be as follows:
Probability
300 people 50%
400 people 30%
500 people 20%
In addition to the sale of the theatre tickets, it can be expected that members of the audience
will also purchase confectionery both prior to the performance and during the interval. The
contribution that this would yield to the theatre is unclear, but has been estimated as follows:
Contribution from confectionery sales Probability
Contribution of $3 per person 0.30
Contribution of $5 per person 0.50
Contribution of $10 per person 0.20
Required:
(a) Using expected values as the basis of your decision, advise the theatre (5 marks)

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 management whether it is financially worthwhile to engage MS for the concert.
(b) Prepare a two-way data table to show the profit values that could occur from
deciding to engage MS for the concert. (5 marks)
(c) Explain, using the probabilities provided and your answer to (b) above, how the
two-way data table can be used by the theatre management to evaluate the
financial risks of the concert, including the probability of making a profit. (9 marks)

Q.4 Lathe Machine

The data for manufacturing 10 lathe machines by a small company is as follows.

Components A B C D E Total
Machine hours 10 14 12 36
Labour hours 2 1 3
Rs. Rs. Rs. Rs. Rs. Rs.
Variable cost 32 54 58 12 4 160
Fixed cost 48 102 116 24 26 316
(apportioned)
Total 80 156 174 36 30 476

Assembly cost (all variable) Rs. 40 per 10 lathe machines.

Selling price Rs. 600 per 10 lathe machines.

General purpose machinery is used to make components A, B and C and is already working
to the maximum capability of 4,752 hours and there is no possibility of increasing the machine
capacity in the next period. There is labour available for making components D and E and
for assembling the product.

The marketing department advises that there will be a 50% increase in demand next period
so the company has decided to buy one of the machine-made component from an outside
supplier in order to release production capacity and thus help to satisfy demand.
A quotation has been received from General Machine Limited for the components, but
because this company has not made these components before, it had not been able to give
single prices its quotation is as follows:

Component Pessimistic Most likely Optimistic

Price(Rs) Probability Price(Rs) Probability Price(Rs) Probability
A 96 0.25 85 0.5 54 0.25
B 176 0.25 158 0.5 148 0.25
C 149 0.25 127 0.5 97 0.25

It has been agreed between the two companies that audited figures would be used to determine
which one of the three prices would be charged for whatever component is brought out.
Required
a Show in percentage form the maximum increased production availability from the
three alternatives i.e. buying A, B or C
b Analyze the financial implications of the purchase, and assuming a risk neutral
attitude, recommend which component to buy out, noting that the production
availability will be limited to a 50% increase.
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Q.5 Sitara Limited
Sitara Limited is a company which engage in site clearance and site preparation work.
Information concerning its operation is as follows.
a) It is company's policy to hire all plant and machinery required for the implementation
of all orders obtained rather than to purchase its own plant and machinery.
b) The company will enter into advance hire agreement at the coming year at one
of three levels; high, medium or low, which correspond to the requirement of the
high, medium or low level of orders obtained.
c) The level of orders obtained will not be known when the advance hire agreement
is entered into. A set of probabilities have been estimated by the management
as to the likelihood of the orders being at a high, medium or low level.
d) Where the advance hire agreement entered into is lower than the required for
the level of orders actually obtained, a premium rate must be paid to obtain the
additional plant and machinery required.
e) No refund is obtainable when the advance hire agreement for plant and machinery
is at a level in excess of that required to satisfy the site clearance and preparation
orders actually obtained.

A summery of the information relating to the above points is as follows:

Equipment hire costs
Level of Turnover Probability Advance Conversion
orders hire premium
Rs. (000) Rs. (000) Rs. (000)
High 15,000 0.25 2,300
Medium 8,500 0.45 1,500
Low 4,000 0.30 1,000

Low to medium 850

Medium to high 1,300
Low to high 2,150
Variable cost ( as percentage of turnover) 70%

Required:
a) On the basis of maximising expected value, advice Sitara Company whether
the advance contract for the hire of plant and machinery should be at the low,
medium or high level.

b) The company is considering employing the market research consultant, who will
be able to say with certainty in advance of the placing of the plant and machinery
hire contract, which level of site clearance and preparation orders will be obtained.
On the basis of expected value, determine the maximum sum which Sitara Company
should be willing to pay the consultant for this information.

Q.6 Meezan Company Ltd are the manufacturers of grass cutting machines, which they have
(May been selling for Rs. 800 per unit for a number of years. The selling price is now under
2007) review, and the following information is available on costs and likely demand:
The standard variable cost of manufacture is Rs. 500 per unit and a cost variance
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 analysis for the last 20 months shows the following trend and that the same is likely to
continue in the future:
10 months - 10% adverse variance occurred
6 months - No variance of standard variable cost
4 months - 5% favourable variance occurred
Monthly data:
Fixed cost have been Rs. 250 per unit on an average sales level of 20,000 units, but these
costs are expected to rise in the future and the following estimate have been made:

Optimistic estimate ( Probability 0.3) Rs 4,100,000

Most Likely estimate ( Probability 0.5) 4,250,000
Pessimistic estimate ( Probability 0.2) 4,500,000
The demand at the two new prices under consideration is as follows:
Selling prices / unit
Estimated demand Rs. 850 Rs. 900
Optimistic estimate ( Probability 0.2) 21,000 19,000
Most Likely estimate ( Probability 0.5) 19,000 17,500
Pessimistic estimate ( Probability 0.3) 16,500 15,500
It is assumed that all estimates and probabilities are independent.
Required:
a) Advice the management, whether they should change the selling price, and
if so, the price you would recommend based on the above information.
b) Calculate the expected profit at your recommended price and resulting
margin of safety, expressed as a percentage of expected sales.
c) Critically comment on the method of analysis you have used to deal with
the probabilities given in the question.

Q7 Zaheer Ltd is a manufacturer of auto parts and is currently operating at below capacity
due to slump in the demand for automobiles. The company has received a proposal
from a truck assembler for supply of 40,000 gear boxes per annum for five years at Rs.
1,900 per gear box.
The cost of each gear box is as follows:
Rupees
Material costs 800
Labour costs 500
Variable production overheads 150
Variable selling overheads 200
Fixed overheads (allocated) 150
Company has already incurred a cost of Rs. 5 million on the preparation of technical
feasibility. The additional cost for setting up the facility for this order would be Rs. 20
million. The company qualifies for tax allowable depreciation on the cost of setting up
the facility on a straight-line basis over the life of the project.
The company has a post-tax cost of capital of 15%. The rate of tax applicable to the
company is 30%.

Required
(a) Evaluate whether the proposal is financially feasible for the company.

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 Assume that revenue and cost of gear box will remain the same during the
next five years.
(b) Carry out a sensitivity analysis to determine which of the following variables
is most sensitive to the feasibility of the order:
Material costs
Labour costs
Additional cost of setup

Q8 JKL Phone Limited is a cellular service provider. The Marketing Director has
recently proposed a marketing strategy which envisages the introduction of a new
package for pre- paid customers, to gain market share. He has carried out a
market research and suggests that the call rates forming part of the proposed
package should either be Re. 0.75 or Re. 1.00 or Rs. 1.25 per minute.
Based on market research, sales demand at different levels of economic growth is
estimated as follows: Call Rates
Rs. 0.75 Re. 1 Rs. 1.25
Probability Subscribers in million
Recession 0.30 0.70 0.50 0.30
Moderate 0.50 0.80 0.60 0.40
Boom 0.20 0.90 0.80 0.60

He foresees that the average airtime usage per subscriber would be 1800 minutes or
1600 minutes with a probability of 40% and 60% respectively. In order to cater to the
increased subscriber base, the company would need to commission new cell sites,
details of which are as follows:
No. of subscribers Cost of new sites (Rs. in million)
Up to 0.5 million 180
Between 0.5 – 0.8 million 300
Between 0.8 – 1.0 million 540

It is assumed that the present customers of the company would continue to use the
existing packages.

Required
Evaluate the proposal submitted by the Marketing Director and advise the most
suitable call rates.
(Ans: Tariff of Re. 1 is most suitable because it gives the highest value of pay-off)

Q 9 RubyTech (Pvt.) Limited is engaged in the business of manufacturing electronic products.

Aug Due to technological obsolescence the products, usually, have a short lifecycle. The company
2019 is aimed to keep manufacturing each product for at least 20 months so that it can recover
the high cost of product development and make an acceptable profit before it becomes
obsolete. The Director Finance of the company has identified an opportunity to export
one of the three newly developed products, `office machines', `telecommunication
equipment' and `integrated circuits & apparatus', to Zimbabwe, due to the increased
demand of electronic products by its citizens as the rate of technological
obsolescence in Zimbabwe is slower than Pakistan.

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The company has consulted its key stakeholders [employees, Directors, and shareholders]
for sharing their views on the proposal of exporting to Zimbabwe and, in particular, which
of the three products to be exported. The employees of the company have a cautious
approach to the proposal, following the recent failure of another product launched, resulted
in lost of jobs by number of employees.

The Directors of the company are keen to earn a bonus, which is currently based on the
total profit made by each of the new product over its lifecycle. The shareholders of the
company are risk neutral, but they are keen that the company should consider the
external environment in Zimbabwe in order to maximize performance there, regardless
of the product being chosen for export.

The market analyses indicate that the foreign exchange rate between Pakistani Rupee
(PKR) and Zimbabwean Dollar (ZWD) is a key economic factor, which may affect the
revenue of the company. Following is the relevant estimated data for each product:

Total Demand Selling Price Total Unit Cost

(Units) (ZWD) (PKR)
Office machines 60,000 100,000 24,000
Telecommunication equipment 70,000 112,500 30,000
Integrated circuits & apparatus 170,000 75,000 25,000

Additional Information:
• The estimated product lifecycle of each product is same and the total demand is for
the whole lifecycle of each product.
• The Director Finance has estimated that over the lifecycle of each product, there is
a 75% probability that the average foreign exchange rate of PKR will be strengthen by
10% against ZWD and a 25% that it will be weaken by 10% against ZWD.
• The current foreign exchange rate between PKR and ZWD is ZWD 2.50 per PKR.
• At current foreign exchange rate, 50% of total unit cost of each product is for the
purchase of raw materials, which are imported from Zimbabwe and invoiced in ZWD.
There will be no opening or closing inventory for any of the new selected product.
• Development costs are sunk costs and can be ignored.

Required:
As a Director Finance of RubyTech (Pvt.) Limited, the Chief Executive Officer (CEO)
has sought your guidance regarding the following:
(a) Advise which of the three newly developed products each of the three key
stakeholders of the company would choose to export to Zimbabwe based
on their respective risk appetites. 14
(b) Based on the answer in part (a) above, explain the problems of using `risk and
uncertainty analysis' techniques. 04

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Decision Tree

A diagram showing several possible courses of action and possible events and the potential
outcomes for each of them.
Each alternative course of action or event is represented by a branch, which leads to subsidiary
branches for further courses of action or possible events. Decision trees are designed to illustrate
the full range of alternatives and events that can occur, under all envisaged conditions.
The value of a decision tree is that its logical analysis of a problem enables a complete strategy
to be drawn up to cover all eventualities before a firm becomes committed to a scheme.

Q.10 Wills Oil Company is faced with the problem of deciding whether or not to drill a well
on newly acquired lease. Based on statistically available information, the probability
of finding no oil is 0.78. If oil is found the company will have Rs. 10 million profit,
however, if oil is not found the company will lose Rs. 3 million.
Before deciding whether or not to drill, the company could pay a seismographic
service company Rs. 500,000 to conduct a seismic test of the proposed site.
There is 0.2 probability that the seismic test result would be favourable, and
a 0.8 probability that it would not. If the results are favourable, the probability
of finding oil would be 0.7 and if the results are unfavourable, the probability
of finding no oil would be 0.9.
Required
Prepare a decision tree

Q.11 SB Company produces and sells nationally a popular soft drink and has enjoyed
goodd profit for many years. In recent years, however, its sales volume has not
grown with the general market. This lack of growth is due to the increasing popularity
of fruit juicemarketing by a competitor.

The company is now developing its own new branded fruit juice and is considering
potential marketing strategies. Introducing this new product would require a large
commitment of resources for a full nationwide introduction because SB is a late entry
into the fruit juice market. SB's advertising agency has helped assess the market risk
and has convinced the SB that there are only two reasonable alternative strategies to
pursue.

Strategy 1.
Perform a test advertising and sales campaign in a limited number of cities for a
six months period. SB would decided whether or not to introduce the fruit juice
nationally and conduct a nation wide promotional campaign on the basis of the
results of the test campaign.

Strategy 2.
Conduct a nationwide promotion campaign and make the new fruit juice available in
whole country immediately, without conducting any test campaign. The nationwide
promotion and distribution campaign would be allowed to run for a full two years .
SB believes that, if strategy 2 is selected there is only a 50% chance of its being
successful. The introduction of fruit juice nationally will be considered a success if
Rs. 40 million of sales target is achieved, while Rs. 30 million variable costs are being
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 incurred during the two years period. If the two year campaign is unsuccessful, sales
are expected to be Rs. 16 million and variable cost to be Rs. 12 million. Total fixed
cost for the two year period is estimated to be Rs. 6 million.

The advertising agency believes that if strategy 1 is selected, there is 20% chances
that the test will indicate that nationwide campaign should be conducted, when in fact
the campaign would be unsuccessful. In addition, there is a 20% chance that the test
result will indicate that SB should not conduct a nationwide campaign, when in fact
a nationwide campaign would be successful. The cost of the test campaign is
estimated to be Rs. 500,000, and the probability of a successful test is 50%.
Required
Prepare a decision tree

Q.12 Galaxy Pharma Ltd., is considering whether to develop and market a new
(May painkiller. Development costs are estimated to be Rs.900,000 and there is a 0.75
2008) probability that the development effort will be successful and a 0.25 probability that
the development will be unsuccessful. If the development is successful, the
product will be marketed and it is estimated that:
1- If the product is very successful, profits will be Rs.2,700,000;
2- If the product is moderately successful, profits will be Rs.500,000;
3- If the product is failure, there will be a loss of Rs.2,000,000;
Each of the above profit and loss calculation is after taking into account the
development costs of Rs.900,000. The estimated probability of each of the above
events are as follows:
1- Very successful 0.4 2- Moderately successful 0.3 3- Failure 0.3
Required:
(a) Prepare a decision tree.
(b) Offer your comments.

Q 13 The directors of Khayyam Limited (KL) are considering an investment proposal which would need
an immediate cash outflow of Rs. 500 million. The investment proposal is expected to have two
years economic life with salvage value of Rs. 50 million at the end of second year.
KL’s Budget and Planning Department anticipates that Net Cash Inflows After Tax (NCIAT) are
dependent on exchange rate of the US $ and has made the following projections:
Exchange Rate Exchange Rate Exchange Rate
Rs. 84-87 Rs. 88-91 Rs. 92-95
NCIAT Pr NCIAT Pr NCIAT Pr
Year 1 250 65% 320 35%
Year 2:
− If Year 1 exchange rate is Rs. 84-87 280 20% 330 65% 360 15%
− If Year 1 exchange rate is Rs. 88-91 340 5% 380 50% 400 45%

All NCIATs are in millions of rupees

KL uses a 14% discount rate for investments having similar risk levels.
Required:
(a) Draw a decision tree to depict the above possibilities. (04 marks)
(b) Determine whether it would be advisable for Khayyam Limited to undertake this project.
(10 marks)

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Q 14 GH Scientific Corporation is assessing the possibility of introducing a new product.
The Incharge of production is confident that the product will be successful.
However, the marketing department is apprehensive of the high cost of production
and has advised that an in-depth market research should be carried out before
launching the product. The cost of initial launch of the product is estimated at Rs.
500 million whereas the cost of carrying out the market research shall be Rs. 100 million.
The company’s research analysts have developed the following estimates:
(i) If the company starts production without carrying out market research, there is a
40% probability that it will earn a profit of Rs. 2 billion from the product, 35% probability
of earning Rs. 1.2 billion and 25% probability of incurring a loss of Rs. 200 million.
(ii) If the company decides to carry out the research there is a 60% probability
that it will find the product feasible.
(iii) If the product is found feasible the chances of profitability are as follows:
Profit of Rs. 2.8 billion 70%
Profit of Rs. 800 million 30%
(iv) If the product is not found feasible the profitability estimates are as follows:
Profit of Rs. 700 million 20%
Loss of Rs. 400 million 80%
Required:
(a) Draw a decision tree to depict the above possibilities.
(b) Determine whether the company should carry out the research or not.

Q 15 The owner of a tourist hotel is facing a difficult decision. It is low season and because the
weather is unpredictable at this time of the year it is difficult to predict the demand for the
hotel’s facilities. If the weather is poor then there will be 200 room nights demanded for the
hotel’s facilities. There is a 70% likelihood of the weather being poor. If the weather is good
then there will be 600 room nights demanded for the hotel’s facilities, but there is only a
30% chance that the weather will be good.

The owner of the hotel is considering advertising some reduced prices locally or nationally
in order to improve the demand during this period.
If the reduced prices are advertised locally and if the weather is poor, then there is a 60%
chance that the lower prices would affect demand and would cause there to be 300 room
nights demanded, but if the weather is good, then there is a 40% chance that the lower prices
would affect demand and would cause there to be 800 room nights demanded.
If these lower prices were advertised nationally there is a 50% chance that these demand
levels would increase to 400 room nights and 900 room nights respectively.
The earnings expected, (before deducting the costs of any local or national advertising), at
different levels of demand are as follows:
Room nights
demanded Earnings ($)
200 (35,000)
300 (15,000)
400 (5,000)
500 20,000
600 30,000
700 45,000
800 65,000
900 90,000
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 The costs of advertising locally and nationally are $10,000 and $25,000 respectively.

Required:
(a) Prepare a decision tree to illustrate the above problem and use this to recommend,
with reasons, the best course of action for the owner of the hotel. (7 marks)

(b) Briefly discuss the limitations of using a decision tree to solve this problem. (3 marks)

Q 16 The Alternative Sustenance Company is considering introducing a new franchised

product, Wholefood Waffles. Existing ovens now used for making some of the present
‘Half-Baked’ range of products could be used instead for baking the Wholefood Waffles.
However, new special batch mixing equipment would be needed. This cannot be
purchased, but can be hired from the franchiser in three alternative specifications, for
batch sizes of 200, 300 and 600 units respectively. The annual cost of hiring the mixing
equipment would be Rs 5,000, Rs 15,000 and Rs 21,500 respectively.

The ‘Half-Baked’ product which would be dropped from the range currently earns a
contribution of Rs 90 000 per annum, which it is confidently expected could be continued
if the product were retained in the range.

The company’s marketing manager considers that, at the market price for Wholefood
Waffles of Rs 0.40 per unit, it is equally probable that the demand for this product would
be 600 000 or 1 000 000 units per annum.

The company’s production manager has estimated the variable costs per unit of making
Wholefood Waffles and the probabilities of those costs being incurred, as follows:

200 units 300 units

Probability Probability
if annual if annual 600 units
sales are sales are Probability 600 units
Batch size: either either if annual Probability
Cost per unit 600 000 or 600 000 or sales are if annual
(pence) 1 000 000 1 000 000 600 000 sales are
units units units 1 000 000
Rs 0.20 0.10 0.20 0.30 0.50
Rs 0.25 0.10 0.50 0.10 0.20
Rs 0.30 0.80 0.30 0.60 0.30

Required:
(i) to draw a decision tree setting out the problem faced by the company, (12 marks)
(ii) to show in each of the following three independent situations which size of mixing
machine, if any, the company should hire:
1 to satisfy a ‘maximin’ (or ‘minimax’ criterion), (7 marks)
2 to maximize the expected value of contribution per annum,
3 to minimize the probability of earning an annual contribution of less than Rs 100 000.

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