Decision Tree Construction

Chang Yung Chong is considering whether to open a new computer store called Power Byte Computers in West Lafayette, Indiana. Mr. Chong wants to proceed cautiously since the market potential for another computer company 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 $5,000. 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 insight from a market potential survey, Mr. Chong believes there is a 50 percent chance 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 the 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.

Homework 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 #3 what is the best-case and worse-case first year net financial result to which Mr. Chong would be exposed?
5. 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 now?