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Additional Questions – Risk and Uncertainty

As in the case of project appraisal I am now coming up with some solid

additional questions. Do work on these to ensure your knowledge of this area is
rock solid.

01.

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 30%
Contribution of $5 per person 50%
Contribution of $10 per person 20%
Required:
(a) Using expected values as the basis of your decision, advise the theatre management whether it is
financially worthwhile to engage MS for the concert.
(5 marks)
(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)
(d) Calculate the maximum price that the theatre management should agree to pay for perfect
information relating to the size of the audience and the level of contribution from confectionery sales.
(6 marks)
(Total for Question Six = 25 marks)

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02.

A health clinic is reviewing its plans for the next three years. It is a not for profit organisation but it has a
financial responsibility to manage its costs and to ensure that it provides a value for money service to its
clients. The health clinic uses the net present value technique to appraise the financial viability of
delivering the service, but it also considers other non-financial factors before making any final decisions.

The present facilities, which incur an annual total cost of £300,000, are only sufficient to meet a low level
of service provision so the manager is considering investing in facilities to meet potential higher levels of
demand. For the purpose of evaluating this decision the possible levels of demand for the health clinic’s
services have been simplified to high, medium or low.

The possible demand for the services in the first year and the level of demand that could follow that
specific level in the next years, and their expected probabilities, are as follows:

Year 1 Probability Years 2 and 3 Probability

Low 30% Low 40%
Medium 60%
High 0%
Medium 50% Low 30%
Medium 40%
High 30%
High 20% Low 0%
Medium 30%
High 70%

The level of demand will be the same in years 2 and 3.

The manager is considering two alternative investments in facilities:

Facility A has the capacity to meet the low and medium levels of demand and requires an investment at
the start of year 1 of £500,000. Thereafter it incurs annual fixed costs of £100,000 and annual variable
costs depending on the level of operation. These annual variable costs are expected to be £150,000 at
the low level of operation and £250,000 at the medium level of operation.

Facility B has the capacity to meet all levels of demand and requires an investment at the start of year 1
of £800,000. Thereafter it incurs annual fixed costs of £200,000 and annual variable costs depending on
the level of operation. These annual variable costs are expected to be £100,000 at the low level of
operation, £150,000 at the medium level of operation and £200,000 at the high level of operation.

Neither of these alternative investments has any residual value at the end of year 3.

If the facilities of the health clinic are insufficient to meet the level of service demand that occurs, the clinic
must obtain additional facilities on a yearly contract basis at the following annual costs:

Level of service provision Level of service provision Annual cost of additional

available internally demanded facilities
Low Medium £100,000
Low High £250,000
Medium High £150,000

These additional facilities are not under the direct control of the health clinic manager.

Note: All monetary values used throughout the question have been stated in terms of their present value.
No further discounting is required.

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Required:
(a) Prepare a decision tree to illustrate the investment decision that needs to be made by the manager of
the health clinic. (Numerical values are NOT required).
(6 marks)
(b) Advise the manager of the health clinic which investment decision should be undertaken on financial
grounds.
(15 marks)
(c) Briefly discuss any non-financial factors that the manager should consider before making her final
investment decision.
(4 marks)
(Total for Question Six = 25 marks)

03.

The following data are to be used when answering questions 3.1 and 3.2
A company expects to sell 1,000 units per month of a new product but there is uncertainty as to both the
unit selling price and the unit variable cost of the product. The following estimates of selling price, variable
costs and their related probabilities have been made:

Selling Price Unit Variable Cost

£ per unit Probability £ per unit Probability
20 25% 8 20%
25 40% 10 50%
30 35% 12 30%

There are specific fixed costs of £5,000 per month expected for the new product.
3.1 The expected value of monthly contribution is
A £5,890
B £10,300
C £10,890
D £15,300
(2 marks)
3.2 The probability of monthly contribution from this new product exceeding £13,500 is
A 24·5%
B 30·5%
C 63·0%
D 92·5%
(2 marks)

04.
A baker is trying to decide the number of batches of a particular type of bread that he should bake each
day. Daily demand ranges from 10 batches to 12 batches. Each batch of bread that is baked and sold
yields a positive contribution of £50, but each batch of bread baked that is not sold yields a negative
contribution of £20.
Assuming the baker adopts the minimax regret decision rule, calculate the number of batches of bread
that he should bake each day. You must justify your answer.
(4 marks)

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05.
A company has estimated the selling prices and variable costs of one of its products as follows:

Selling price per unit Variable cost per unit

$ Probability $ Probability
40 0·30 20 0·55
50 0·45 30 0·25
60 0·25 40 0·20
Given that the company will be able to supply 1,000 units of its product each week irrespective of the
selling price, and that selling price and variable cost per unit are independent of each other, calculate the
probability that the weekly contribution will exceed $20,000.
(3 marks)