Decision Analysis 2016

Problem Set-2
1. Techware Incorporated is considering the introduction of two new software products to the market. Depending upon
market conditions, they may decide to introduce none, one or both products. R&D costs for the two products are
$180,000 and $150,000 respectively. The success of these products depends on the trend of economy in the coming year.
The following table summarizes the companys revenues expected under the various states of the economy, and the
probabilities of such economy:
Revenues Expected

Trend in economy
Strong

Fair

Weak

Introduce neither product

$0

$0

$0

Introduce Product 1 only

$500,000

$260,000

$120,000

Introduce Product 2 only

$420,000

$230,000

$110,000

Introduce both products

$820,000

$390,000

$200,000

Probabilities

0.3

0.5

0.2

(a) Based on the maximum EMV approach, what is the optimum decision?
(b) What is the EVPI in this situation?
(c) Suppose Mr. Albright is an expert in predicting economic conditions. However, his predictions are not always fully
accurate. The table next page lists the probabilities with which his predictions have been found to be accurate:
Strong Trend

Fair Trend

Weak Trend

Predicted Strong Trend

0.7

0.2

0.1

Predicted Fair Trend

0.1

0.8

0.1

Predicted Weak Trend

0.05

0.2

0.75

Techware is considering using Mr. Albrights services before entering in any R&D. What is the maximum amount that
Techware can pay for Mr. Albrights services? You may assume that based on Mr. Albrights advice, Techware would
take the decision that is the best for them, and that they are aware of the above probabilities.
2. i) Burger Prince Restaurant is considering opening a new restaurant on Main Street. It has three different models, each
with a different seating capacity. Burger Prince estimates that the average number of customers per hour will be 80, 100,
or 120, with initial probabilities of 0.4, 0.2 and 0.4 respectively. The payoff table for the three models is the following:

Average Number of Customers per Hour

s1 = 80

s2 = 100

s3 = 120

Model A

$10,000 $15,000

$14,000

Model B

$ 8,000

$18,000

$12,000

Model C

$ 6,000

$16,000

$21,000

(a) Draw a decision tree and recommend a model using EMV approach.
(b) Calculate the EVPI.
ii) Burger Prince decides to purchase a marketing survey from Stanton Marketing. The results of the survey are either
"favorable" or "unfavorable". The conditional probabilities are:
P(favorable | 80 customers per hour) = 0.2
P(favorable | 100 customers per hour) = 0.5
P(favorable | 120 customers per hour) = 0.9
Draw another decision tree to analyze the modified problem using EMV approach. What is the Expected Value of Sample
Information (EVSI)? How efficient is the survey from Stanton Marketing?
3. The game of craps requires the player to throw two dice once or more times until a decision has been reached as to
whether he wins or loses. He wins if the first throw results in a sum of 7 or 11, or, alternatively, if the first sum is 4, 5, 6,
8, 9 or 10 and the same sum appears before a sum of 7 appears. Conversely, he loses if the first throw results in a sum of
2, 3 or 12, or, alternatively, if the first sum is 4, 5, 6, 8, 9 or 10 and a sum of 7 appears before the first sum appears.
Our goal is to compute the probability of winning through simulation.
a) Simulate one throw of the two dice.
b) Simulate one complete game where the player either wins or loses.
c) Estimate the probability of winning through 100 simulations of the game. What is the standard error of your estimate?
Note: The standard error for estimated proportion p , over n trials, is given by

p)

p(1
.
n

4. The process of applying for renewal of passports in a small city is the following. The applicant goes to the passport
office and joins a queue to get their file prepared. There are three people preparing the files. Once an applicant reaches
the head of the queue, they are guided to the next available person among the three who will prepare their file. (Only one
per-son prepares an applicants file.) The time required to prepare an applicants file follows an exponential distribution
with a mean of 5 minutes.
On obtaining their file, the applicant joins a queue for the next stage in which their bio-metric data is obtained. There are
12 kiosks for this stage. Once they reach the head of this queue, an applicant is guided to the next available kiosk. The

biometric equipment at any kiosk has a 10% chance of breaking down at any stage. In case the equipment at a kiosk is
functioning, this stage requires 3 minutes, and in case the equipment breaks down, then the time required for this process
follows a shifted exponential distribution with a minimum processing time of 10 minutes and mean processing time of
15 minutes. An applicant is NOT allowed to change kiosks even if the equipment at a particular kiosk breaks down.
Once an applicants biometric data are collected, they join the queue for the last stage where their documents are
checked. There are two people checking the documents, and each applicants document is checked by one person. When
an applicant reaches the head of this queue, they are guided to the next person available to check their documents. The
document checking process requires time that is uniformly distributed (i.e., has a rectangular distribution) between 10
minutes and 20 minutes. Once this stage is over, the applicants application process is complete and the applicant is free
to leave.
Six people, A, B, C, D, E, and F are scheduled to apply for renewal of passports on a particular day. They arrive in the
same order (i.e., A followed by B, followed by C and so on) and join the queue for getting their files prepared. All of
them arrive before the office opens.
Assume that the time the passport office opens is 0 minutes and simulate the application process for the six people using
the random numbers provided in the next page in the sequence in which they are provided, and answer the questions
given below.
(a) At what time points do the six applicants join the queue for submitting their biometric data?

For each person who is at the head of the queue to submit the biometric data, choose a pair of random
numbers consecutive in sequence from the random numbers given above. Use the first random number to
simulate whether or not the biometric equipment is functioning and the other to find the time they require to submit the
data. For example, if you decide to choose random numbers 29 and 30 for an applicant, use the 29th random number to
simulate whether or not the biometric equipment is functioning and the 30th random number to simulate the time
required.

(b) At what time points do the six applicants join the queue for the last stage?

(c) Develop a 95% confidence interval for the average time required from joining the queue for submitting biometric
data till the time the process of collecting biometric data is complete.
(d) At what time points do the six applicants complete their processes of application for renewal of passports?
(e) Develop a 95% confidence interval for the average time required to apply for renewal of passports.
(f) Now repeat the analysis of (a)-(e) for 300 applicants through Excel.
5. Silja Line is considering the purchase of a new cargo ferry for $ 8 million. The yearly forecast revenues are assumed to
follow normal distribution with the expected value of the previous years realized cash flows, with an initial $ 5 million for
the 1st year and a standard deviation of $ 1 million. The yearly operating cost follows normal distribution with an
expected value of $4 million and a standard deviation of $ 0.5 million. In addition, theres a major refit that will be
required after both the 5th and 10th year, where the cost follows uniform distribution between $1.5 to $2.5 million. After
15 years, the ferry can be sold for a residual value that has a uniform distribution between 0 to $3 million.
(a) Simulate 600 replications to estimate the probability that buying the ship is profitable (>0).
(b) Estimate the net present value (NPV) of the ferry if the required rate of return is 7%.
(c) Present the histogram of the NPV graphically.
(d) Estimate the standard deviation of the NPV and the standard error of the NPV.
(e) Would it be worthwhile to buy the ship?
6. Consider two stocks, A and B, and let Sa(t) and Sb(t) be the time t prices of A and B, respectively. At time t = 0, I buy
na units of A and nb units of B so my initial wealth is W0 = naSa(0)+nbSb(0). Suppose my investment horizon is T years
after which my terminal wealth, WT, is given by WT = naSa(T)+nbSb(T). Note that this means that I do not trade in [0,T].
Assume Sa GBM(a,a), Sb GBM(b,b), and that Sa and Sb are independent. We would now like to estimate P(WT /
W0 .9), i.e., the probability that the value of my portfolio drops by more than 10%.
Note that we may write:
Sa(T) = Sa(0) exp((a 2a/2)T +aBa(T))
Sb(T) = Sb(0) exp((b 2b/2)T +bBb(T))
where Ba and Bb are independent SBMs.
B(T) = N(0, T), i.e normally distributed random number with zero mean and variance T.
Assume the following parameter values: T = .5 years, a = .15, b = .12, a = .2, b = .18, Sa(0) = $100, Sb(0) = $75 and na
= nb = 100. Compute the probability by generating a sample of size 1000.