Chapter 10: Risk and Uncertainty

Combi plc are having problems with one of their offices and have decided that there are three courses of action available to them:

(a) shut down the office, raising proceeds of $5 million;
(b) have an expensive refurbishment of the office costing $4,000,000;
(c) have a cheaper refurbishment of the office at a cost of $2,000,000.

If they do the expensive refurbishment, then a good result will yield a return of $13,500,000 whereas a poor result will yield a present value of only $6,500,000. If they alternatively decide to do the cheaper refurbishment, then a good result will yield a return of $8,500,000 whereas a poor result will yield $4,000,000. In either case, the probability of the refurbishment achieving a good result has been estimated to be 2/3.

An independent company has offered to undertake market research for them in order to identify in advance whether the result of refurbishment is likely to be good or poor. The research will cost $200,000 and there is a 68% probability that it will indicate a good result. Unfortunately, the research cannot be guaranteed to be accurate. However, if the research indicates a good result, then the probability of the actual result being good is 91%. If the survey indicates a poor result, then the probability of the actual result being good is 13%.

Combi have already decided that if they do have market research, and if the research indicates a poor result, then they will only be prepared to consider the cheaper refurbishment.

The tree is labelled as the tutor draws it: decision node 1 is the first decision (shut, expensive, cheaper or research); chance nodes A and B follow the expensive and cheaper refurbishments without research; chance node F is the research result; decision node 2 follows a GOOD indication (chance nodes C and D), and decision node 3 follows a POOR indication (chance node E, or shut). Work in $ million.