Profit ($1000s) High Demand 0.85 2650 Build Complex 8 Moderate Demand Forecast High 5 650 0.15 0.6 Sell 1150 Market Research High Demand 0.225 2650 Build Complex Moderate Demand Forecast Moderate 0.4 650 0.775 Win Contract 3 Sell 0.8 1150 High Demand 2800 0.6 Build Complex (10) Moderate Demand Bid No Market Research 800 0.4 Sell 1300 1 Lose Contract - 200 0.2 Do Not Bid
Dante Development Corporation is considering bidding on a contract for a new office
building complex. The following figure shows the decision tree prepared by one of
Dante’s analysts. At node 1, the company must decide whether to bid on the contract. The
cost of preparing the bid is $200,000. The upper branch from node 2 shows that the company
has a 0.8 probability of winning the contract if it submits a bid. If the company wins
the bid, it will have to pay $2 million to become a partner in the project. Node 3 shows that
the company will then consider doing a market research study to forecast demand for the
office units prior to beginning construction. The cost of this study is $150,000. Node 4 is
a chance node showing the possible outcomes of the market research study.
Nodes 5, 6, and 7 are similar in that they are the decision nodes for Dante to either build
the office complex or sell the rights in the project to another developer. The decision to
build the complex will result in an income of $5 million if demand is high and $3 million if
demand is moderate. If Dante chooses to sell its rights in the project to another developer,
income from the sale is estimated to be $3.5 million. The probabilities shown at nodes 4,
8, and 9 are based on the projected outcomes of the market research study.
a. Verify Dante’s profit projections shown at the ending branches of the decision tree by
calculating the payoffs of $2,650,000 and $650,000 for first two outcomes.
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