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Decision Tree

Please help me find the right track to approach this problem, I am lost and need some insight whether or not what models to use or what resources to use in order to find the particular answer, it is so very confusing, any help with the matter to get me the right start and a hint on the design of what they want and what to hear would be great. I need to present this to a group and need to make it professional, managed and reach the right answers otherwise I am stuck and I will get a bad overall grade and a bad participation grade, any help will be wonderful, thanks!

Power Byte Computers

Chang Yung Chong is considering whether to open a new computer store called Power Byte Computers in West Lafayette, IN. Mr. Chong wants to proceed cautiously since the market potential for another computer store is uncertain. He can either open a small store now, open a large store now, drop the idea now, or else have a market potential study conducted and then decide whether to open a small or large store or do nothing. A marketing research firm has offered to conduct a market potential survey for $5000.00. The survey would suggest either a favorable or unfavorable market for a new computer store.

Based on Mr. Chong's calculations, he believes that if a small store is opened he would earn a first-year profit of $30,000 in a favorable market, but would lose $10,000 the first year in an unfavorable market. If a large store is opened he believes he would earn $60,000 the first year in a favorable market, but lose $35,000 the first year in an unfavorable market. Without the insight from a market potential survey, Mr. Chong believes there is a 50 percent change that the market will be favorable.

In initial discussions with the marketing research firm, the marketing analyst guessed that there was a 60 percent chance that a survey would suggest a favorable market. Reluctantly, the analyst admitted that marketing surveys do not always assess markets correctly. Upon further prodding by Mr. Chong, the analyst estimated that if the survey suggested a favorable market then the chance of the market actually being favorable was 90 percent. But if the survey suggested an unfavorable market, there would still be a 15 percent chance that the market would actually be favorable. Mr Chong is feeling rather perplexed by this time.

Assignment:

1. Why do you think the decision of what to do seems difficult to Mr. Chong?

2. Construct a decision tree representing all possible actions, events, and payoffs.

3. Analyze your decision tree, computing all the expected values, and recommend what Mr. Chong should do (Explain completely).

4. With your recommendation in Number 3, what is the best-case and worst-case first-year net financial result to which Mr. Chong would be exposed?

5. If Mr. Chong has now decided that he does not want to be exposed to any first-year net loss over $25,000. This means he no longer wants to consider opening a large store. What would you recommend to Mr. Chong now?

Solution Preview

Please see the attached word file 'Solution' for answers to the above questions.

The excel file 'Decision Tree' contains the decision tree for question 2.

Assignment:

1. Why do you think the decision of what to do seems difficult to Mr. Chong?

The decision seems difficult to Mr. Chong because of the following reasons:

a. Because of the unpredictable nature of the survey (given posterior probabilities) it is difficult to make a decision just by looking at the data.
b. The expected payoffs can be calculated only for the first year. Some long term estimates would have helped in taking a decision.

2. Construct a decision tree representing all possible actions, events, and payoffs.

Please see file titled Decision Tree.xls

3. Analyze your decision tree, computing all expected values, and recommend what Mr. Chong should do ...

Solution Summary

This posting provides a detailed solution to the problem.

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