Marie Bernadine P.
Ylaya BSA 1E September 25, 2022
Assignment 5 - Decision Tree
Dante Development Corporation is considering bidding on a contract for a new
office building complex. Figure 13.19 shows the decision tree prepared by one of
Dante’s analysts. At node 1, 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 0.8 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, and 7 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 the first two
outcomes.
i. Payoffs of $2,650,000
= (Expected Income) - (Expenses)
= $5,000,000 - ($200,000 + $2,000,000 + $150,000)
=$5,000,000 - $2,350,000
=$2,650,000
ii. Payoffs of $650,000
= (Expected Income) - (Expenses)
= $3,000,000 - ($200,000 + $2,000,000 + $150,000)
=$3,000,000 - $2,350,000
=$650,000
b. What is the optimal decision strategy for Dante, and what is the expected profit
for this project?
i. If forecast is high:
Build Complex = (0.85)(2,650,000) + (0.15)(650,000)
= 2,252,500 + 97,500
= $2,350,000
ii. If forecast is moderate:
Build Complex = (0.225)(2,650,000) + (0.775)(650,000)
= 596,250 + 503,750
= $1,100,000
iii. Do market research:
Build Complex = (0.6)(2,350,000) + (0.4)(1,100,000)
= 1,410,000 + 440,000
= $1,850,000
iv. Do not do market research:
Build Complex = (0.6)(2,800,000) + (0.4)(800,000)
= 1,680,000 + 320,000
= $2,000,000
The optimal decision strategy is to build a complex without doing market research. Its
expected profit will be $2,000,000.
c. What would the cost of the market research study have to be before Dante
would change its decision about the market research study?
i. Do not do market research
Build Complex
= (0.6)(2,800,000) + (0.4)(800,000)
= 1,680,000 + 320,000
= $2,000,000
Sell
= $1,300,000
ii. Do market research
Forecast High
Build Complex
= (0.85)(2,650,000) + (0.15)(650,000)
= 2,252,500 + 97,500
= $2,350,000
Sell
= $1,150,000
Forecast Moderate
Build Complex
= (0.225)(2,650,000) + (0.775)(650,000)
= 596,250 + 503,750
= $1,100,000
Sell
= $1,150,000
Market Research = Forecast High (0.6) + Forecast Moderate (0.4)
= $2,350,000 (0.6) + $1,150,000 (0.4)
= $1,410,000 + 460,000
= $1,870,000
iii. Cost of Market Research = No Market Research - With Market Research
= $2,000,000 - $1,870,000
= $130,000
The cost of the market research would have to decrease by at least $130,000
d. Develop a risk profile for Dante.
Bid → Win Contract → No Market Research → Build Complex → High Demand;
Moderate Demand
Payoff ($ 1000s) Probability
- $200 0.20
$800 0.32
$2,800 0.48
Total Probability: 1.00
Build Complex at Moderate Demand Probability
= (0.8)(0.4)
= 0.32
Build Complex at High Demand Probability
= (0.8)(0.6)
= 0.48
