Show me the steps to solve AK Steel Holding Corporation is a producer of flat-rolled carbon, stainless and electrical steels and tubular products through its wholly owned subsidiary, AK Steel Corporation. The recent decline in the demand for steel prompted AK executives to look for new ways to cut costs, so they are considering a research project to improve production of rolled steel. The research involves three distinct steps, each of which must be successfully completed before the firm can implement the cost-saving new production process. If the research is completed successfully, it will save the firm $4 million. Unfortunately, there is a chance that one or more of the research steps might fail, in which case the project is worthless. The three steps are done sequentially so that the firm knows whether one step was successful before it has to invest in the next step. Each step has a 0.8 probability of success and each step costs $500,000. The risks of failure in the three steps are uncorrelated with one another. Assume that AK Steel is a risk neutral company (i.e., that it maximizes expected values). In case you are worried about such things, the interest rate is zero. a) Draw the decision tree for the firm. After the firm has successfully completed steps one and two, it discovers an alternate production process that would cost $150,000 and would lower production costs by $1,000,000 with certainty. This process, however, is a substitute for the three-step cost-saving process; they cannot be used simultaneously. Furthermore, to have this process available, the firm must spend the $150,000 before it knows if it will successfully complete step three of the three-step research project. f) Draw the decision tree faced by the firm after it has successfully completed steps one and two, including the possibility of pursuing this alternate production process
Show me the steps to solve AK Steel Holding Corporation is a producer of flat-rolled carbon, stainless and electrical steels and tubular products through its wholly owned subsidiary, AK Steel Corporation. The recent decline in the demand for steel prompted AK executives to look for new ways to cut costs, so they are considering a research project to improve production of rolled steel. The research involves three distinct steps, each of which must be successfully completed before the firm can implement the cost-saving new production process. If the research is completed successfully, it will save the firm $4 million. Unfortunately, there is a chance that one or more of the research steps might fail, in which case the project is worthless. The three steps are done sequentially so that the firm knows whether one step was successful before it has to invest in the next step. Each step has a 0.8 probability of success and each step costs $500,000. The risks of failure in the three steps are uncorrelated with one another. Assume that AK Steel is a risk neutral company (i.e., that it maximizes expected values). In case you are worried about such things, the interest rate is zero. a) Draw the decision tree for the firm. After the firm has successfully completed steps one and two, it discovers an alternate production process that would cost $150,000 and would lower production costs by $1,000,000 with certainty. This process, however, is a substitute for the three-step cost-saving process; they cannot be used simultaneously. Furthermore, to have this process available, the firm must spend the $150,000 before it knows if it will successfully complete step three of the three-step research project. f) Draw the decision tree faced by the firm after it has successfully completed steps one and two, including the possibility of pursuing this alternate production process
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Transcribed Image Text:Show me the steps to solve AK Steel Holding Corporation is a producer of flat-rolled carbon, stainless and electrical
steels and
tubular products through its wholly owned subsidiary, AK Steel Corporation. The recent decline in
the demand for steel prompted AK executives to look for new ways to cut costs, so they are
considering a research project to improve production of rolled steel. The research involves three
distinct steps, each of which must be successfully completed before the firm can implement the
cost-saving new production process. If the research is completed successfully, it will save the firm
$4 million. Unfortunately, there is a chance that one or more of the research steps might fail, in
which case the project is worthless. The three steps are done sequentially so that the firm knows
whether one step was successful before it has to invest in the next step. Each step has a 0.8
probability of success and each step costs $500,000. The risks of failure in the three steps are
uncorrelated with one another. Assume that AK Steel is a risk neutral company (i.e., that it
maximizes expected values). In case you are worried about such things, the interest rate is zero.
a) Draw the decision tree for the firm.
After the firm has successfully completed steps one and two, it discovers an alternate production
process that would cost $150,000 and would lower production costs by $1,000,000 with certainty.
This process, however, is a substitute for the three-step cost-saving process; they cannot be used
simultaneously. Furthermore, to have this process available, the firm must spend the $150,000
before it knows if it will successfully complete step three of the three-step research project.
f) Draw the decision tree faced by the firm after it has successfully completed steps one and
two, including the possibility of pursuing this alternate production process
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