Chapter 5, Problem 21P

a)

Summary Introduction

To determine: The best decision when Mr. T is assumed to possess the semiconductor.

Introduction: Expected monetary value (EMV) is a calculation system for expected returns for the certain decision made by a company.

Answer to Problem 21P

The best decision is to purchase the semiconductor.

Explanation of Solution

Given information:

Startup cost	$1,000,000
Vendor development cost	$1,000,000
Redesign	$1,000,000
Purchase cost	$500,000

Make	Good	0.4			Startup cost
	Fail	0.6	Reevaluate	Good (0.9)	Startup cost& redesign
				Fail (0.1)	Startup cost, Vendor development cost, redesign, purchase cost
			Buy		Startup cost, Vendor development cost, purchase cost
Buy					Vendor development cost, purchase cost

Calculation of EMV:

Startup cost	$1,000,000				Total cost
Vendor development cost	$1,000,000
Redesign	$1,000,000
Purchase cost	$500,000
Make	Good	0.4			$1,000,000
	Fail	0.6	reevaluate	Good (0.9)	$2,000,000
				Fail (0.1)	$3,500,000
			buy		$2,500,000
Buy					$1,500,000

Table 1

Excel Worksheet:

Make:

Probability 0.4:

When the condition is good, the total cost to make semiconductors with a probability of 0.4 is startup cost which is $1,000,000.

Probability 0.6:

When the condition is not satisfactory with the probability of 0.6, either reevaluation or buying decisions can be made.

• Reevaluate:

    On reevaluation, either it can turn out to be good or bad condition with probability 0.9 and 0.1 respectively.

    When the condition is good, the total cost is obtained by the sum of startup $1,000,000 and redesign cost $1,000,000 which yield $2,000,000.

    When reevaluation fails, the total cost is obtained by the sum of startup $1,000,000, redesign cost $1,000,000, vendor development cost $1,000,000 and purchase cost $500,000 which yields $3,500,000.

• Buy:

    When the condition fails, the firm has to go for the buying options which is obtained by the sum of a startup $1,000,000, vendor development cost $1,000,000 and purchase cost $500,000 which yields $2,500,000.

Buy

The total cost to make purchase decision is the sum of vendor development cost $1,000,000 and purchase cost $500,000 which yields $1,500,000.

EMV to make semiconductor:

  EMV, when condition is good with probability 0.4 is,

$\begin{array}{l}=\left(\$1,000,000\times 0.4\right)\\ =\$400,000\end{array}$

  EMV, when condition is not satisfactory with probability 0.6 is,

• Reevaluate:

  $\begin{array}{l}=\left(\$2,000,000\times 0.9\right)+\left(\$3,500,000\times 0.1\right)\\ =\$2,150,000\end{array}$

• Buy:

Since no probabilities are given, the total cost is the EMV value when the condition is not satisfactory and the firm goes for buying options. So, the EMV is $2,500,000.

On comparing both EMV’s, the EMV to reevaluate is smaller than EMV to buy. So, the option of re-evaluation is selected.

EMV to make semiconductor:

$\begin{array}{l}=\left(1,000,000\times 0.4\right)+\left(2,150,000\times 0.6\right)\\ =\$1,690,000\end{array}$ (1)

Therefore, the EMV to make semiconductor is $1,690,000.

EMV to buy semiconductor:

Since no probabilities are given, the total cost is the EMV value when the firm goes for buying options. So, the EMV is $1,500,000.

Therefore, the EMV to buy semiconductor is $1,500,000. (2)

From equation (1)and (2), it is recommended to buy the semiconductor than to make it because of least EMV.

Conclusion

Hence, it is recommended to buy the semiconductor.

b)

Summary Introduction

To determine: The criteria used in decision making.

Answer to Problem 21P

The criteria used to make is Expected Monetary Value which is based on the minimum cost method.

Explanation of Solution

Given information:

Startup cost	$1,000,000
Vendor development cost	$1,000,000
Redesign	$1,000,000
Purchase cost	$500,000

Make	Good	0.4			Startup cost
	Fail	0.6	Reevaluate	Good (0.9)	Startup cost& redesign
				Fail (0.1)	Startup cost, Vendor development cost, Redesign, Purchase cost
			Buy		Startup cost, Vendor development cost, Purchase cost
Buy					Vendor development cost, Purchase cost

It can be inferred that the criteria used in decision making is Expected Monetary Value (refer Table (1)) which is based on the least cost method.

Hence, Expected Monetary Value method is used to make decisions.

c)

Summary Introduction

To determine: The worst and the best outcome to Mr. T as a result of the decision made.

Answer to Problem 21P

The worst that can happen to Mr. T is that he fails in his reevaluations attempt, spends $3,500,000 and finally end up buying the semiconductors. The best that can happen to Mr. Tis that he makes semiconductors and spends $1,000,000.

Explanation of Solution

Given information:

Startup cost	$1,000,000
Vendor development cost	$1,000,000
Redesign	$1,000,000
Purchase cost	$500,000

Make	Good	0.4			Startup cost
	Fail	0.6	Reevaluate	Good (0.9)	Startup cost& redesign
				Fail (0.1)	Startup cost, Vendor development cost, Redesign, Purchase cost
			Buy		Startup cost, Vendor development cost, Purchase cost
Buy					Vendor development cost, Purchase cost

Conclusion

Hence, the worst that can happen to Mr. T is that he fails in his reevaluations attempt, spends $3,500,000 and finally end up buying the semiconductors. The best that can happen Mr. Tis that he makes semiconductors and spends $1,000,000. (Refer Table (1)).