Question 1. Kalypo, Inc., is considering a $5 million research and development (R&D) project. Profit projections appear promising, but Kalypo's president is concerned because the probability that the R&D project will be successful is only 0.50. Furthermore, the president knows that even if the project is successful, it will require that the company build a new production facility at a cost of $20 million in order to manufacture the product. If the facility is built, uncertainty remains about the demand and thus uncertainty about the profit that will be realized is summary in the table below. Another option is that if the R&D project is successful, the company could sell the rights to the product for an estimated $25 million. Under this option, the company would not build the $20 million production facility.

a. Analyze the decision tree to determine whether the company should undertake the R&D project. If it does, and if the R&D project is successful, what should the company do? What is the expected value of your strategy?

b. What must the selling price be for the company to consider selling the rights to the product?

c. Develop a risk profile for the optimal strategy.

Question 2. The Gorman Manufacturing Company must decide whether to manufacture a component part at its Milan, Michigan, plant or purchase the component part from a supplier. The resulting profit is dependent upon the demand for the product. The following payoff table shows the projected profit (in thousands of dollars).

State of Nature

Low Demand          Medium Demand       High Demand

Decision Alternativess₁                              s₂                                 s₃

Manufacture, d₁-20                            40                               100

Purchase, d₂ 10                            45                               70

The state-of-nature probabilities are P (s1) = .35, P (s2) = .40, and P (s3) =.25.

a. Draw the decision tree associated with this problem.

b. What is Gorman's optimal decision strategy?What is the expected value of this strategy?

c. Develop a risk profile for the optimal strategy.

d. Use EVPI to determine whether Gorman should attempt to obtain a better estimate of demand.

Question 3. Dantey Development Corporation is considering bidding on a contract for a new office building complex. Dantey's Company must decide whether to bid on the contract or not. The cost of preparing the bid is $200,000. Based on past experience the company has a 0.80 probability of winning the contract if it submits a bid. If the company wins the bid, it will have to pay $2,000,000 to become a partner in the project. Dantey Company will consider doing a market research study to forecast demand for the office units prior to beginning construction if the company wins the contract. The cost of this study is $150,000. The possible outcomes of the market research study can either be high or moderate forecasts. The likelihood of high forecast is 0.60. Dantey CEO must decide either to build the office complex or sell the rights in the project to another developer upon wining the contract whether the market research study was conducted or not. The decision to build the complex will result in an income of $5,000,000 if demand is high and $3,000,000 if demand is moderate. If Dantey chooses to sell its rights in the project to another developer, income from the sale is estimated to be $3,500,000. Past experience has shown that there is 0.85 probability of high demand if the complex is built and forecast is high. Similarly, there is 0.225 chance of high demand if the office complex is built and forecast is moderate. If no market research exists then the probability of high demand is estimated to be 0.60.

a. Develop a decision tree for the Dantey Development Company problem.

b. What is the optimal decision strategy for Dantey, and what is the expected value for this project?

c. What would the cost of the market research study have to be before Dante would change its decision about conducting the study?