Study Unit 7: Relevant Information for Decision Making

Self-Assessment Solution

Question 1

a.

Daily Sales Number of Days Probability

20 73 0.2
35 255 0.7
42 37 0.1

b. Decision Tree

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The conditional profit must now be calculated for each alternative

Qty Production Demand Unsold Purchase Profit /

Sales Cost Loss

1 20 000 20 000 100 000 60 000 40 000

2 20 000 35 000 100 000 60 000 40 000

3 20 000 42 000 100 000 60 000 40 000

4 35 000 20 000 100 000 15 000 105 000 10 000

5 35 000 35 000 175 000 105 000 70 000

6 35 000 42 000 175 000 105 000 70 000

7 42 000 20 000 100 000 22 000 126 000 (4 000)

8 42 000 35 000 175 000 7 000 126 000 56 000

9 42 000 42 000 210 000 126 000 84 000

Backward Induction

Buy 20 = (40 000 x 0.2) + (40 000 x 0.7) + (40 000 x 0.1) = 40 000

Buy 35 = (10 000 x 0.2) + (70 000 x 0.7) + (70 000 x 0.1) = 58 000

Buy 42 = (-4 000 x 0.2) + (56 000 x 0.7) + (84 000 x 0.1) = 46 800

c. Advice:

 The conclusion from the diagram is that 35 million loaves should be

produced per day because it gives the highest probable (expected
value) profit of R58 million

 The scenario is also less risky based on the probability and market
demand

 To produce 42 million loaves will be considered but it is riskier

 If more the 35 million loaves are not sold to the public the home
industry will make a loss of R4 million

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Question 2

Group of outcomes Outcome Number Conditional Profit Probability Weighted

Profit

1-3

1 1 000 000 0.2 200 000

2 1 500 000 0.6 900 000

3 2 000 000 0.2 400 000

Total for the group 1.0 1 500 000

4-6

4 875 000 0.2 175 000

5 1 312 500 0.6 787 500

6 2062 500 0.2 412 500

Total for the group 1.0 1 375 000

Calculation

Estimated income Estimated expenses Estimated [conditional Profit]

1 500×10000=5 000 000 500×8000=4 000 000 1 000 000

2 750×10000=7 500 000 750×8000= 6 000 000 1 500 000

3 1000×10000=10 000 000 1000×8000=8 000 000 2 000 000

4 500×10000=5 000 000 500×8250=4125000 875 000

5 50×10000=7 500 000 750×8250=6137500 1 312 500

6 1000×10000=10 000 000 6187500+250×7000=7937500 2 062

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The highest expected profit is R1 500 000, which means that it would be
advisable to put together their own packages. This will ensure that they
maximise their profit.

Question 3

Solution

Z could use any of the following three approaches to dealing with uncertainty
“Maximin”: the decision maker will look at the options and choose the one that
has the highest minimum return. This type of decision maker is a pessimist and
will look at the worst outcome for each of the options and seeks to get the best
of the worst. “Maximax”: the decision maker will look at the options and choose
the one that has the highest return. This type of decision maker is an optimist.

“Minimax Regret”: the decision maker will analyse the options and choose the
option so that if it is the wrong choice the regret will not be as big as if the
others had been chosen and they were wrong. This type of decision maker seeks
to minimise the post-event regret of having made a wrong decision.

If probabilities can be assigned to the outcomes then “uncertainty” will become

“risk”. It will then be possible to calculate “expected values”. The decision maker
will choose the outcome that has the highest expected value. This assumes that
the decision maker is risk neutral. The expected value of an option does not
give any indication of the risk associated with the option. The risk, or spread, of
the possible outcomes of each option can be measured by calculating the
standard deviation. A risk minimiser would choose the option with the lowest
standard deviation. The trade-off between risk and return can be evaluated by
calculating the coefficient of variation (standard deviation divided by expected
value)

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Question 4

a.

b. Selling price is R8 Contribution of R4 per muffin sold

Each unsold muffin will be sold at a loss of R1 to fans

The conditional profit must now be calculated for each alternative

Qty Purchased Demand Unsold Purchase Profit /

Units Units Cost Loss

1 30 000 30 000 120 000 120 000

2 30 000 40 000 120 000 120 000

3 30 000 50 000 120 000 120 000

4 40 000 30 000 10 000 160 000 110 000

5 40 000 40 000 160 000 160 000

6 40 000 50 000 160 000 160 000

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 7 50 000 30 000 20 000 200 000 100 000

8 50 000 40 000 10 000 200 000 150 000

9 50 000 50 000 200 000 200 000

c. Backward Induction

Buy 30 000 = (120 000 x 0.3) + (120 000 x 0.6) + (120 000 x 0.1) =
R120 000

Buy 40 000 = (110 000 x 0.3) + (160 000 x 0.6) + (160 000 x 0.1) =
R145 000

Buy 50 000 = (100 000 x 0.3) + (150 000 x 0.6) + (200 000 x 0.1) =
R140 000

d. A risk averse manager will go for 40 000 muffins to get maximum expected
value of R145 000 while a risk taker will try to maximise profits and go for
optimum 50 000 muffins with the probability of attaining maximum profits
of R200 000

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Question 5

 The project with the highest expected value (EV) should be undertaken. √√
EV Calculations:

Project A = (0.25 * 250 000) + (0.40 * 235 000) + (0.35 * 275 000) √√
= R 252 750√√

Project B = (0.25 * 200 000) + (0.40 * 275 000) + (0.35 * 285 000) √√
= R 259 750 √√

Project C = (0.25 * 225 000) + (0.40 * 200 000) + (0.35 * 237 500) √√
= R 219 375√√

Project D = (0.25 * 180 000) + (0.40 * 200 000) + (0.35 * 210 000) √√
= R 198 500√√

Hence, solely based on the expected value calculations, Project B should be

selected. √√

• When using the expected value technique, it is necessary to:

o Estimate all possible outcomes of the decision√

o It is important to consider non-financial issues (E.g. Competitor

reactions) when making the final decision. √√ However the EV
technique does not account for non-financial issues√√

o Assign probabilities to all financial outcomes of the decision√

o It is important to consider the sensitivity of cash flows and

probabilities in making the final decision. √√ However the EV
technique does not account for these sensitivities. √√

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Question 6

Decision Point 1 Expected Value: 0.40 (6 500 000) + 0.60 (2 500 000) = R 4
100 000 √√ Cost: = (R 2
000 000) √ Net Return = R 2 100
000 √√

Decision Point 2 Expected Value: 0.40 (3 500 000) + 0.60 (1 500 000) = R 2
300 000 √√ Cost: = Nil √
Net Return = R 2 100 000 √√
Hence, the expected value for decision point two is greater than that of decision
point one, so based on this the company should not expand the factory. √ It is
important, however, to note that the decision will lie with management√√. Non-
financial and qualitative factors may also come into consideration when making
the decision. Non-financial factors may include the specification of the new
equipment, offices and/or the “new look and feel” in the new building whilst
qualitative factors include the impact that expanding/not expanding would have
on staff and shareholders’ morale √√√ *****Note to marker: Accept other
logical, well explained examples of non-financial and/or qualitative factors

Question 7

A sunk cost is a cost already incurred (and is not relevant for investment
decisions). √√ Example: Research and development. √√

Question 8

Solution: The project with the highest expected value (EV) should be
undertaken. √√ EV Calculations:

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Project A = (0.25 * 250 000) + (0.40 * 235 000) + (0.35 * 275 000) √√
= R 252 750√√

Project B = (0.25 * 200 000) + (0.40 * 275 000) + (0.35 * 285 000) √√
= R 259 750 √√

Project C = (0.25 * 225 000) + (0.40 * 200 000) + (0.35 * 237 500) √√
= R 219 375√√

Project D = (0.25 * 180 000) + (0.40 * 200 000) + (0.35 * 210 000) √√
= R 198 500√√

Hence, solely based on the expected value calculations, Project B should be

selected. √√

 When using the expected value technique, it is necessary to:

o Estimate all possible outcomes of the decision√
o It is important to consider non-financial issues (E.g. Competitor
reactions) when making the final decision. √√ However the EV
technique does not account for nonfinancial issues√√
o Assign probabilities to all financial outcomes of the decision√
o It is important to consider the sensitivity of cash flows and
probabilities in making the final decision. √√ However the EV
technique does not account for these sensitivities. √√

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