3. Nick has plans to open some pizza restaurants, but he is not sure how many to

Question

3. Nick has plans to open some pizza restaurants, but he is not sure how many to open. a payoff table to help analyze the situation. He has prepared Alternatives States of Nature Good Fair MarketMarket Market Poor en 1 380,000 70,000 200,000 Open 2 Do Nothing 80,000200,000 0 As Nick does not know how favorable the market will be but assumes that there is a 40% chance of having a good market, a 50% chance of having a fair market and a 10% chance of having a poor market How much should he be willing to pay a consulting firm to help him in making this decision? A) $192,000 B) $147,000 C) $45,000 D) $92,000 E) $47,000 .An investor wants to select one of six mutual funds for the coming year. Data showing the nnual return for each fund during 4 typical one-year periods are shown here. The assumpti indc rill orcur again during the coming year. Thus, years A, B,

Explanation / Answer

To decide this we need expected pay-offs for each case, which is given by

E(Open 1) = 0.4*380000+0.5*70000+0.1*-400000= $147,000

E(Open 2) = 0.4*200000+0.5*80000+0.1*-200000= $100,000

E(Do nothing)=0

So if he opens 2 restaurants without any information on the market, he will get $100,000 on average but if he is given proper information about the market the average return he may get with that information is $ 147,000. So the maximum amount that Nick can pay for the consulting firm will be the difference between them, which is given as the expected value of the information = 147000-100000=$47,000.

Thus the answer is (E) $47,000.

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