Module 4 – SLP
RISK: EXPONENTIAL SMOOTHING FORECASTING AND VALUE OF
INFORMATION
Risk: The Value of Information
Scenario: Using the same situation from the Module 3 SLP,
recall that you are deciding among three investments. You have heard of an
expert who has a highly reliable âtrack recordâ in the correct identification
of favorable vs. unfavorable market conditions. You are now considering whether
to consult this âexpert.â Therefore, you need to determine whether it would be
worth paying the expertâs 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 âFavorableâ
.9
.3
Predicts âUnfavorableâ
.1
.7
You realize that this situation is a bit complicated since
it requires the expert to analyze and predict the state of two different
markets: the real estate market and the retail hat market. You think through
the issues of probabilities and how to calculate the joint probabilities of
both markets going up, both going down, or one up and the other down. Based on
your original estimates of success, here are your calculations of the single
probabilities and joint probabilities of the markets.
Probabilities
Favorable
Unfavorable
A: Real Estate
0.50
0.50
B: Just Hats
0.75
0.25
Joint Probabilities
A Fav, B Fav (A+, B+)
0.375
A Unf, B Unf (A-, B-)
0.125
A Fav, B Unf (A+, B-)
0.125
A Unf, B Fav (A-, B+)
0.375
Finally, after a great deal of analysis and calculation, you
have determined the Posterior probabilities of Favorable and Unfavorable
Markets for the Real Estate business and the boutique hat business.
Real Estate
Just Hats
F
U
F
U
0.45
says “F/F”
0.75
0.25
0.90
0.10
0.15
says “F/U”
0.75
0.25
0.30
0.70
0.30
says “U/F”
0.125
0.875
0.90
0.10
0.10
says “U/U”
0.125
0.875
0.30
0.70
For example, this table says that there is 45% chance that
the expert will predict Favorable for both markets (F/F), and when he makes
this prediction, there is a 75% chance that the Real Estate market will be
favorable and 25% chance that it wonât, and also a 90% chance that the Hat
market will be Favorable and 10% chance it wonât.
You have developed a Decision Tree showing the original
collapsed solution and also showing an expanded Decision Tree for evaluating
the value of the expertâs information. You need to enter the probabilities into
this tree to see if the expertâs information will increase the overall expected
value of your decision. Download the Excel file with the incomplete Decision
Tree: Decision Tree for BUS520 SLP 4
Assignment
Complete the information in the Decision Tree in the Excel
file. Determine the Expected NPV of the decision if you were to consult the
Expert. Does use of the Expert increase the value of your analysis? If so, by
how much?
Write a report to your private investment company and
explain your analysis and your recommendation. Provide clear rationale/
justification for your decision.
Upload both your written report and Excel file with the
Decision Tree analysis to the SLP 4 Dropbox.
SLP Assignment Expectations
Analysis
Accurate and complete analysis in Excel.
Required:
Length requirements: 2â3 pages minimum (not including Cover
and Reference pages). NOTE: You must submit 2â3 pages of written discussion and
analysis. This means that you should avoid use of tables and charts as âspace
fillers.â
Provide a brief introduction to/background of the problem.
Written analysis that supports Excel analysis and provides
thorough discussion of assumptions, rationale, and logic used.
Complete, meaningful, and accurate recommendation(s).
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