Notes 1.

7 Planning and Decision Analysis Lecture II

Associated Reading: Ch04 & 05
Examples of Excellent Discussion Forum Submissions
Assignment Due: Field Interview Questions
Groups for Lab Next Week (Group 1 lab Monday, Group 2 lab Wednesday)
Discuss Online Budget Planning Assignment Due Sep 24th at 8:00am
--------------------------------------------------------------------------------------------Car Insurance problem: You are trying to decide how large of deductible to carry on your car insurance for next
year. You can either choose $500 or $1000. You can also opt to not buy insurance at all (you must not live in the
United States).
For the general population, there is 15% chance that one will get in an accident in any given year. If you do get into
an accident that is a 10% chance that it will be a major accident and total you car, which is worth $6000. There is a
40% chance that the damages will be moderate, costing $3000, and a 50% that the damages will be minor, costing
only $500.
If you have insurance, you only have to pay your deductible in the event that you get in an accident. If you choose
to have no insurance, then you must pay for all damages in the event that you get into an accident. The downside
to buying the insurance is that you have to pay the premiums. The annual premium for a policy with a $500
deductible is $1200. The annual premium for a policy with a $1000 deductible is $800
Make a decision tree to decide whether to buy a policy with a $500 deductible, $1000 deductible, or opt to have no
insurance.

Decision-Making Under Risk: Separating the Quality of the Decision from the
Outcome
Can good decisions have bad outcomes?
Circle One:

YES

or

NO

Managers are responsible for evaluating the performance/decisions of others it is critical

that they understand this point.
Historians Fallacy
This fallacy, which is credited to David Hackett Fischer, occurs when it is assumed that
people in the past viewed events with the same information or perspective as those
analyzing these past events from a (relative) future.
The fallacy has the following form:
1. From the present perspective event A in time T is seen as X (a good idea, significant,
a bad idea, etc.)
2. Therefore event A was (or should have) been seen as X at time T.

Expected Value Decision Method - When the probabilities of each outcome are available,
the expected value criterion is used to select the alternative that will produce the greatest
average payoff or minimum average loss.
Assumptions/Considerations
The expected value criterion assumes a linear value function for money. This
assumption may be false for some decisions.
An increase from 0 to 100k may be regarded by the decision maker as much more
preferable than an increase from 800k to 900k.
If you are unemployed, a job that pays 20K but requires you to 7 days per week may
be attraction.
By comparison, if you currently have a job that pays 80k, you may not be willing to
work weekends in order to earn 20k of additional income.

The expected value criterion does not take into account the attitude to risk of the
decision maker.

In-Class Case Study Problem (3 points possible)

Please work in groups of 2-3 people and turn one copy neatly written at the end of class
today.
Applied (Large-Scale) Construction Management Problem

Dante Development Corporation is considering bidding on a contract for a new office building complex.
Figure 19.9 shows the decision tree prepared by one of Dante's analysts. At node I, the company must
decide whether to bid on the contract. The cost of preparing the bid is $200,000. The upper branch
from node 2 shows that the company has a .8 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.
Node 3 shows that the company will then consider doing a market research study to forecast demand
for the office units prior
to beginning construction. The cost of this study is $150,000. Node 4 is a chance node showing the
possible outcomes of the market research study. Nodes 5, 6, and7 are similar in that they are the
decision nodes for Dante to either build the office complex or sell the rights in the project to another
developer. 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 Dante chooses to sell its rights in the project to another
developer, income from the sale is estimated to be $3,500,000. The probabilities shown at nodes 4, 8,
and 9 are based on the projected outcomes of the market research study.
a. Verify Dante's profit projections shown at the ending branches of the decision tree by calculating the
payoffs of $2,650,000 and $650,000 for first two outcomes.
b. What is the recommend decision strategy for Dante, and what is the expected profit 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?

Another Applied Problem in Construction Management (As Time Permits)

A real estate investor has the opportunity to purchase land currently zoned residential. If the county
board approves a request to rezone the property as commercial within the next year, the investor will
be able to lease the land to a large discount firm that wants to open a new store on the property.
However, if the zoning change is not approved, the investor will have to sell the property at a loss.
Profits (in thousands of dollars) are shown in the following payoff table:

Purchase
Do Not
Purchase

Rezoning Outcome
Approved
Not Approved
600k
-200k
0
0

a. If the probability that the rezoning will be approved is .5, what decision is recommended? What is
the expected profit?
b. The investor can purchase an option to buy the land. Under the option, the investor maintains the
rights to purchase the land any time during the next three months while learning more about possible
resistance to the rezoning proposal from area residents. Probabilities are as follows.
Let H indicate the event that the area residents are highly-resistant to rezoning.
Let L indicate the event that the area residents express only low-resistant to rezoning.
The probability of H = 0.55.
The probability of L = 0.45.
Now, the probability of rezoning approval if H occurs is 0.18.
Now, the probability of rezoning approval if L occurs is 0.89.
What decision strategy is recommended if the investor uses the option period to learn more about the
resistance from area residents before making the purchase decision?
c. If the option will cost the investor an additional $10,000, should the investor purchase the option?
Why or why not? What is the maximum that the investor should be willing to pay for the option?

In Class Participation Problem: You are trying to decide how large of deductible to carry on your car insurance
for next year. You can either choose $500 or $1000. You can also opt to not buy insurance at all (you must not live
in the United States).
For the general population, there is 15% chance that one will get in an accident in any given year. If you do get into
an accident that is a 10% chance that it will be a major accident and total you car, which is worth $6000. There is a
40% chance that the damages will be moderate, costing $3000, and a 50% that the damages will be minor, costing
only $500.
If you have insurance, you only have to pay your deductible in the event that you get in an accident. If you choose
to have no insurance, then you must pay for all damages in the event that you get into an accident. The downside
to buying the insurance is that you have to pay the premiums. The annual premium for a policy with a $500
deductible is $1200. The annual premium for a policy with a $1000 deductible is $800
Make a decision tree to decide whether to buy a policy with a $500 deductible, $1000 deductible, or opt to have no
insurance.

Suggested Practice Problems w/ Answers

Example: Small Business Location

Gary, a small business owner is considering opening a second location of his business and has secured the property.
He has determined his options for leasing property as: commit to a two-year lease at $50,000 per year or commit to
a one-year lease at $60,000. At the beginning of the second year, Gary can cancel the two-year lease at a cost of
$20,000 or continue with the lease. If he only signed a one-year lease initially, he has the option of renewing the
lease for another year at $60,000.

Based on previous experience in the business and his research on the new location, Gary estimates there is a 40%
chance that sales (net of cost of goods sold) in the first year will be considered good and will amount to $100,000;
alternatively, they will only amount to $30,000. If sales in year one were good, the chance of them being good
in year two as well is 80%. However, if sales in year one were bad, the probably of them being bad in year two
as well is 90%. Good sales in year two also amount to $100,000; bad sales in year two also amount to $30,000.
Provide a recommendation for Gary.

Answer: Gary should sign a 2 yr lease and then continue regardless of what sales are in year 1. Expected profits
under this decision are 14.6k.

Example: Dairy Farm Expansion

Demand has grown at Dairy Farms, and they are considering expanding. One option is to expand by purchasing a
very large farm that will be able to meet expected future demand. Another option is to expand the current facility
by a small amount now and take a wait-and-see attitude, with the possibility of a larger expansion in two years.
Management has estimated the following chances for demand: The likelihood of demand being high is 70%. The
likelihood of demand being low is 30%.
Profits for each alternative have been estimated as follows: Large expansion has an estimated profitability of either
40k or 20k, depending on whether demand turns out to be high or low. Small expansion has a profitability of 15k
assuming that demand is low. Small expansion with an occurrence of high demand would require considering
whether to expand further. If the company expands at that point, the profitability is estimated to be 35k. If it does
not expand further, the profitability is estimated to be 12k. What should the Dairy Farm do?

Answer: The expected profits under a small expansion are 29k. The expected profits under a large expansion are
34k. Therefore, the Dairy Farm should opt for the large expansion.