Adventure Limited (AL) is considering the replacement of one of its machines. The company has shortlisted the available options to three machines: Machine Alpha, Machine Beta and Machine Gamma. Regardless of the choice of machine, the company will be subject to three states of nature: high demand, medium demand and low demand. The net profits generated by each of the machines under the three states of nature are as follows:
Adventure Limited (AL) is considering the replacement of one of its machines. The company has shortlisted the available options to three machines: Machine Alpha, Machine Beta and Machine Gamma. Regardless of the choice of machine, the company will be subject to three states of nature: high demand, medium demand and low demand. The net profits generated by each of the machines under the three states of nature are as follows:
|
|
|
Net profit (£000) |
|
|
|
High demand |
Medium demand |
Low demand |
|
Machine Alpha |
5,000 |
4,000 |
3,000 |
|
Machine Beta |
8,000 |
3,000 |
2,000 |
|
Machine Gamma |
6,500 |
5,000 |
1,500 |
The probabilities of the states of nature are as follows:
High demand 20%
Medium demand 50%
Low demand 30%
Required:
1. Determine the choice of machine using the following decision rules:
-
- Maximin
- Maximax
- Regret criterion
Expected value
2.A consultant is confident that he can perfectly forecast the level of demand. Determine the maximum price that AL should pay for the perfect information.
3.Briefly explain how the decision rules in part (a) relate to the risk attitudes of decision makers.
4.The finance director of AL believes that traditional investment appraisal will adequately support all types of capital investment decisions.
Evaluate the belief of the finance director.
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