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Decision analysis tree

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Decision analysis tree

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Doug wants to determine the possible action for an asset worth $25000 that he bought long ago, an investor is offering Doug $275000 for the asset. If the real estate market goes through a boom, he will lose $1.5 million, if the market remains high, he will gain $4 million dollars. There are two options that Doug has to go for either to develop the site or sell the site;

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Options develop the sitesell the site

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Bad market conditions$1.5 million0

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Good market conditions$4 million$275000

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3400425774700025908002108200 $4 million

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3505200-127000847725381000015240039814425000

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0025000

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$1.5million

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3571875369570007715255797550079057525590500 $1.5 million

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354330027305000350520048387000 $1.5 million

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$0

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Therefore the overall decision is to develop the site, since there is a higher return from developing the site than disposing it to the buyer.

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Problem 2:

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Cutler-Hammer was offered an option (at a cost of $50,000) giving it the chance to obtain a license to produce and sell a new flight safety system. The company estimated that if it purchased the option, there was a 0.30 probability that it would not obtain the license and a 0.70 probability that it would obtain the license. If it obtained the license, it estimated there was a 0.85 probability that it would not obtain a defense contract, in which case it would lose $700,000. There was a 0.15 probability it would obtain the contract, in which case it would gain $5.25 million.

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If Cutler-Hammer wants to maximize its expected return, use a decision tree to show whether or not the company should purchase the option. What is the expected payoff?

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Suppose the company after purchasing the option, can sublicense the system. Suppose there was a 95% chance of zero profit and a 5% chance of a $1,000,000 profit. Would this new alternative change your decision above?

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Cost = $50000, C

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Probability not to obtain the license = 0.3, P(N)

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Probability to obtain the license =0.7, P(O)

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If the license is obtained;

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Probability not to obtain a defense contract = 0.85, P(D)

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Lose = $700000

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Probability to obtain a defense contract = 0.15, P(NO)

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5334000200660P(D)

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00P(D)

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Gains = $5.25 million

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28384506604000Decision tree;

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2295525253365P(0)

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00P(0)

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3009900119380054292511938000

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5410200327660P(NO)

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0P(NO)

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26574752145665P(N)

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00P(N)

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54292510312400028575574040C

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00C

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expected pay-off = P(O) P(D)

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=0.7(700000)

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=$49000

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Expected pay-off =P(O) P(NO)

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=0.7(5.25)

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=$3.675 million

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No, the decision couldn’t have changed my option since there is higher returns in the first option than the later, hence, I would opt going with the probability that it would be obtained without a defense contract.

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