AP-6,

Chapter 15 AP1(p651)

Consider a firm that is deciding whether to operate plants only in the United States or also in either Canada or Mexico or both. Congress is currently discussing an overseas investment in new capital (OINC) tax credit for US firms that operate plants outside the country. If congress passes the OINC in2011, management expects to do well if it is operating plants in Mexico and Canada. If OINC does not pass in 2011 and the firm does operate plants in both Canada and Mexico, it will incur rather large losses. It is possible that Congress will table OINC in 2011 and wait until 2012 to vote on it. The profit payoff matrix (profits in 2011) is shown here:

States of nature .
OINC passes / OINC fails / OINC stalls
Operate plants in US only / $10 million / -$1 million / $2 million
Operate plants in US and Mexico / $15 million / -$4 million / $1.5 million
Operate plants in US, Mexico and Canada / $20 million / -$6 million / $4 million

Assuming the managers of this firm have no idea about the likelihood of congressional action on OINC in 2011, what decision should the firm make using the following rules?

a)Maximax rule

b)Maximinrule

c)Minimax regret rule

d)Equal probability rule

AP-9,

Return to AP 6(the above problem scenario) and suppose the managers of the firm decide on the following subjective probabilities of congressional action on OINC:

Probability
OINC passes / 40%
OINC fails / 10%
OINC stalls / 50%

a)Compute the expected profits for all three decisions

b)Using the expected value rule, which option should the managers choose and why?

c)Compute the standard deviations for all three decisions. Using the mean variance rule, does any one of the decisions dominate? If so, which one and why?

d)What decision would the firm make using the coefficient of variation rule?

AP-4

Jo Thomkins must decide whether or not to proceed with a particular investment project. If the project succeeds, Jo will gain $15 million. If the project fails, she will lose $3 million. Jo estimates that there is a 20% chance that the project will succeed and an 80% chance that it will fail.

A consultant could tell Jo with certainty if the project will succeed or fail, but only for a fee. What is the most that Jo should be willing to pay the consultant for the information? Explain. Assume that Jo has correctly estimated the probabilities of the project’s likely success and failure.