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Decision Tree and Estimation

Mark is looking at the forecasts of expected economic growth. He plans to invest $120,000 in an investment whose return would depend on the economic conditions. It is estimated that the economy will have a high growth with a probability of 25%, normal growth with a probability of 50% and a slow growth with a probability of 25%. An investment is likely to provide an expected return of 20% if the economy has a rapid growth, 14% if the economy has normal growth and 8% if the economy grows slowly. In order to get more information, Mark has approached an economist who can provide a better estimate. The economist would charge $15,000 for providing his estimate. The economist predicts the following probabilities: High growth: 40%; normal growth: 40%; and slow growth: 20%.

Construct a decision tree and advise whether use of the services of economist is justified.

Solution Preview

Please refer attached file for decision tree.

Net Expected Return in case own estimates are ...

Solution Summary

Solution draws a decision tree representing the given situation and checks if the use of the services of economist is justified.

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