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Activity - Decision Tree

The Americo Oil Company is considering bidding $112 million on a shale oil development contract from the federal government with a 60% chance of winning. If awarded the contract, the company could develop a new extraction process with a 30% chance of great success worth $600 million, use an existing inefficient process with a 50% chance of great success worth $300 million, or subcontract processing for guaranteed profits of $250 million. The decision tree analysis found the expected value of bidding to be $208 million, higher than the $30 million from alternative investment, so the company should make a bid.

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Tee Mendoza
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1K views

Activity - Decision Tree

The Americo Oil Company is considering bidding $112 million on a shale oil development contract from the federal government with a 60% chance of winning. If awarded the contract, the company could develop a new extraction process with a 30% chance of great success worth $600 million, use an existing inefficient process with a 50% chance of great success worth $300 million, or subcontract processing for guaranteed profits of $250 million. The decision tree analysis found the expected value of bidding to be $208 million, higher than the $30 million from alternative investment, so the company should make a bid.

Uploaded by

Tee Mendoza
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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The Americo Oil Company is considering making a bid for a shale oil development contract to be awarded

by the federal government. The company has decided to bid P 112 million. The company estimates that it
has a 60% chance of winning the contract with this bid. If the firm wins the contract, it can choose one of
three methods for getting the oil from the shale. It can develop a new method for oil extraction, use an
existing (inefficient) process, or subcontract the processing to a number of smaller companies once the
shale has been excavated. The results from these alternatives are as follows:

Develop new process:

Outcomes Probability Profit


Great success 0.30 P 600,000,000
Moderate success 0.60 P 300,000,000
Failure 0.10 (P 100,000,000)

Use present process:

Outcomes Probability Profit


Great success 0.50 P 300,000,000
Moderate success 0.30 P 200,000,000
Failure 0.20 (P 40,000,000)

Subcontract:
Outcome Probability Profit
Moderate success 1.00 P 250,000,000

The cost of preparing the contract proposal is P 2 million. If the company does not make a bid, it will invest
in an alternative venture with a guaranteed profit of P 30 million. Construct a sequential decision tree for
this decision situation and determine whether the company should make a bid.

SOLUTIONS:
Great Success 7 0.30 x P 600,000,000

Moderate Success 8 0.60 x P 300,000,000 Expected Value = 350 M


350 M

Develop 4 9 0.10 x (P 100,000,000)


Failure

208 M Present 202 M


Great Success
10 0.50 x P 300,000,000
60% - win Moderate Success
To Bid -2M 5 11 0.30 x P 200,000,000 Expected Value = 202 M
2 Subcontract Failure

12 0.20 x (P 40,000,000)
1 40% - lose 250 M
Moderate Success
6 13 1.0 x P 250,000,000 Expected Value = 250 M
-2M
To Invest
3

30 M

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