Decision Analysis Solution


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  1. What is Decision Analysis? When is it most useful?  Briefly outline a generic Decision Analysis process.  How can a decision maker clearly communicate the objectives of a decision. (20 Points)

 

Answer:

  1. Decision analysis is the process that based on the philosophy, theory, methodology and professional practice that is necessary for the formal decision making. It require many procedures, methods and tools for presenting the decision making, for this purpose there is recommended course of actions that are required compulsory for formal presentation of decision making process.
  2. Decision analysis is useful when the consequences of actions are uncertain. This method is used in the business administration to make the investment decisions. In oil companies it used for selecting the promising sites for wells.
  3. Decision Analysis process

Decision analysis process consist of 7 following steps

 

1 Identify a problem or opportunity

The first step is to recognize a problem or to see opportunities.

 

2 Gather information

 

 

 

3 Analyze the situation

 

 

4 Develop options

 

 

5 Evaluate alternatives

 

 

6 Select a preferred alternative

 

 

7 Act on the decision

 

 

 

  1. Communicate your Decision

When you decision has made communicate it to each person who will be affected by it in an engaging or inspiring way. It is better if you involved them in implementing the solution. When you provide more information greater will be chances to get more benefit.

  1. You are the CEO of Cardinal Company (a small handheld technology firm) and have just been briefed on a promising new product with projected cash flows detailed below. Discuss your assessment of this project’s viability and profitability.  Explain the principles of evaluating cash inflows and outflows. Calculate payback period, total return on investment, internal rate of return, and net present value.  State any assumptions (i.e. discount rate).  Explain your reasoning behind those assumptions.

 

 

Answer:

 

Year Revenue Capital Expenditures Net Cash flow Cumulative Net Cash flow
2016 $18,000,000 –          18,000,000 – 18,000,000
2017 $3,000,000 $3,000,000 – 1,50,00,000
2018 $4,000,000 $4,000,000 – 1,10,00,000
2019 $6,500,000 $6,500,000 – 45,00,000
2020 $7,500,000 $3,500,000 $4,000,000 – 5,00,000
2021 $7,500,000 $7,500,000 70,00,000
2022 $8,000,000 $1,500,000 $6,500,000 1,35,00,000
2023 $8,500,000 $8,500,000 2,20,00,000
2024 $9,000,000 $2,000,000 $7,000,000 2,90,00,000
2025 $9,500,000 $9,500,000 3,85,00,000

 

We see that Cumulative net cash flow turns positive in year 2021, by the start of 2012, 5 years of operation are completed. Therefore, payback period is as follows

 

Payback period = 5 + (500000) / (4000000) = 5.07 years

 

Total Return on Investment = Total Profit / Total investment = (Total Revenue – Total Total Capital Expenditures) / Total Capital Expenditures

 

= (63,500,000 – 25,000,000) / 25,000,000 = 38,500,000 / 25,000,000

 

= 154 %

 

 

 

IRR Calculations

Net Cash flow Factor at

25.5%

-18000000
$3,000,000 0.796813 2390438.247
$4,000,000 0.634911 2539642.228
$6,500,000 0.505905 3288381.371
$4,000,000 0.403111 1612445.661
$7,500,000 0.321204 2409032.363
$6,500,000 0.25594 1663608.006
$8,500,000 0.203936 1733456.09
$7,000,000 0.162499 1137491.692
$9,500,000 0.129481 1230070.697
NPV 4566.355503

 

Net Cash flow Factor at 25.6%
-18000000
$3,000,000 0.796178 2388535.032
$4,000,000 0.6339 2535599.821
NPV -57511.8159

 

So IRR is 25.5% because at this rate NPV more close to zero.

 

 

NPV calculation

 

NPV at 10%

Calculation of NPV at interest rate of 10% is = $ 15,630,971

  1. The Monticello Room Company is a toy manufacturing company interested in expanding its product line to the development and manufacturing of simple robots for to help children with learning. In order to obtain the engineering and production capacity to enter this market the company will either have to build a new facility or expand and upgrade its current facilities.  The development team has narrowed the alternatives to two approaches to obtain the required capacity: (1) a new facility, at a cost of $45 Million, or (2) expansion/upgrade of current facilities, at a cost of $25 Million.  Both approaches would require the same amount of time for implementation.

 

A rigorous study conducted by a team of economic and financial experts indicates that over the required payback period, demand for the product will either be high or moderate.  Since high demand is considered to be somewhat less likely than moderate demand, the probability of high demand has been estimated at 0.35.  If demand is high, a new facility would result in an additional $75 Million in revenue, but expansion/upgrade only an additional $45 Million, due to lower maximum production capability.  On the other hand if demand is moderate, the comparable figures would be $30 Million for a new facility and $20 Million for expansion/upgrade. (All costs and profit values are figured on a present value, using an appropriate rate of return)

 

If Cardinal wishes to maximize its expected monetary value, should it obtain a new facility or expand? Provide a decision tree or some other means of representing your calculation. What other factors (besides EMV) might play into Cardinal’s decision whether to modernize or expand?  (10 Points)

 

75

Answer:

 

30
45
20
25
45
0.65
0.65
0.35
0.35

 

 

 

 

Payoff for Expand / upgrade

Total cost: $25 MN

Profit = 0.35*45 + 0.65 * 30 = 35.25

So, Profit – cost =$10.25 MN

 

Since, the payoff from Expand/upgrade is positive, it will be the preferred option. Returns from the new facility are in negative, so that the option will not be taken up.