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DECISION TREE AND VALUE OF INFORMATION

May 6, 2023

Scenario: You are deciding among three investments, as you do for Case 4. You have heard of an expert who has a highly reliable “track record” in the correct identification of favorable vs. unfavorable market conditions. You are now considering whether to consult this “expert.” Therefore, you need to determine whether it would be worth paying the expert’s fee to get his prediction. You recognize that you need to do further analysis to determine the value of the information that the expert might provide. In order to simplify the analysis, you have decided to look at two possible outcomes for each alternative (instead of three).

You are interested in whether the market will be Favorable or Unfavorable, so you have collapsed the Medium and Low outcomes. Here are the three alternatives with their respective payoffs and probabilities. Option A: Real estate development. This is a risky opportunity with the possibility of a high payoff, but also with no payoff at all. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the Net Present Value (NPV) of the payoffs and probabilities: High/Favorable NPV: $7.5 million, Pr = 0.5 Unfavorable NPV: $2.0 million, Pr = 0.5 Option B: Retail franchise for Just Hats, a boutique-type store selling fashion hats for men and women. This also is a risky opportunity but less so than Option A. It has the potential for less risk of failure, but also a lower payoff. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the NPV of the payoffs and probabilities. High/Favorable NPV: $4.5 million, Pr = 0.75 Unfavorable NPV: $2.5 million, Pr = 0.25 Option C: High Yield Municipal Bonds. This option has low risk and is assumed to be a Certainty. So there is only one outcome with probability of 1.0: NPV: $2.25 million, Pr = 1.0 You have contacted the expert and received a letter stating his track record which you have checked out using several resources. Here is his stated track record: True State of the Market Expert Prediction Favorable Unfavorable Predicts “Favorable” .9 .3

#DECISION #TREE #INFORMATION

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