A company is deciding whether or not to go ahead with a project. If the project

Question

A company is deciding whether or not to go ahead with a project. If the project is successful, the company will make $500,000 profit. If the project fails, the company's net loss will be $250,000. The probability of the project’s success is 0.5.

a) What should the company do?

b) If perfect information about the success or failure of this project was available, how much would this information be worth?

c) Perform sensitivity analysis on P.

The company occasionally hires consultant to update their estimates of success/failure. Consultant predicts either success or failure for the project; in either case the company must decide whether or not to go ahead with the project. The company is considering hiring one of the two consultants, Harry or Sally. Both charge $10,000 for their services.

The following prior probabilities were determined based on Harry’s and Sally's previous predictions:

P(Harry predicts success when project succeeded) = 0.8

P(Harry predicts failure when project failed) = 0.8

P(Sally predicts success when project succeeded) = 0.1

P(Sally predicts failure when project failed) = 0.1

d) Of the two consultants, whose predictions are more valuable to the company (if at all)? Explain your answer

Explanation / Answer

(a) EV (Go ahead) = 0.5*500,000 +0.5*-250,000 = 125,000, EV (do not go ahead) = 0. So the company should go ahead with the project.

(b) EVwPI = 0.5*500,000 + 0.5*0 = 250,000. EVPI = EVwPI – EV(Goahead) = 125,000. So perfect information is worth 125,000

(c) If Harry predicts success, company should go ahead with project, otherwise not.

Harry EV = 0.8*500 + 0.2*-250 + 0 = 350    

If Sally predicts failure, company should go ahead with the project, otherwise not.

Sally EV = 0 + 0.9*500 + 0.1*-250 = 425

(d) As evident from part (c), Sally’s prediction yield higher EV. Hence, Sally’s predictions are more valuable. Interestingly though company’s decision would be opposite from Sally’s recommendation. However, the inverse accuracy of Sally’s prediction makes her prediction more reliable and valuable for the company.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.