Executive Summary 3
Introduction 4
Decision Making 4
Decision Table 4
Figure 1. Decision table 5
Decision Making Under Uncertainty 5
Figure 2. Uncertainty decision 5
Optimistic 5
Pessimistic 5
Criterion of Realism 6
Equally Likely 6
Minimax Regret 6
Expected Monetary Value 7
Figure 3. EMV when no additional information was gathered 7
Figure 4. EMV with a favorable result from the additional information 8
Figure 5. EMV with an unfavorable result from the additional information 8
Figure 6. EMV from the additional information 9
Conclusion and Recommendation 9
References 10
Appendices 11
Analytical Experience and Plans 13
Executive Summary
Management decisions have always been considered a difficult task especially when a company has a limited amount of resources to spend on their investment. This is the case for the company owner when he planned to build either a quadplex or duplex but is uncertain to the choice due to a limited budget. There are four choices, which are (1) to build a quadplex, (2) build a duplex, (3) acquire additional information, or (4) pass on the investment. In order to develop a relevant and profitable decision the report applied the use of different decision models, which were segregated into (1) a decision table, (2) decision making under uncertainty, and (3) decision making under risk. The purpose of which is to develop a conclusion and recommendation to improve the company profits by deciding on a profitable choice.
The use of the decision tree along with the examination of decision making under uncertainty and risk revealed that the company has two potential alternatives, which is to build the quadplex or do nothing. The reason for this is that a favorable market will result in higher profits but this also incurs the highest risk for potential losses. The decision tree revealed that the acquisition of additional information is an unnecessary cost since the probability percentage of 0.7 will result in a positive and realistic profit of $4,500 when building a quadplex when compared to a profit of only $2,750 with the additional information. Therefore the recommendation is build the quadplex while minimizing costs by not acquiring additional information.
Construction Problems: A Managerial Report
Management decisions have always been considered a difficult choice especially when a company has a limited amount of resources. The reason is that wrong business decisions can often lead to losses and higher costs rather than the generation of profits. This is especially true in the construction business where a significant number of competitors are operating in the same industry and location. The main problem is that the proposed project is the development of a rental property, which means that profitability is dependent on the market and property location.
The owner and project manager, Bill Holiday, has a limited amount of funds to use in the construction investment. There are four choices, which are (1) to build a quadplex, (2) build a duplex, (3) acquire additional information, or (4) do nothing. In order to develop a relevant and profitable decision the report applied the use of different decision theories, which are segregated into (1) a decision table, (2) decision making under uncertainty, and (3) decision making under risk. The purpose is to enhance the company profitability by choosing the alternative with the highest potential for investment success while minimizing additional costs to the company.
Decision Making
Decision Table
The decision table in figure 1 below revealed that the most optimistic alternative is the building of the quadplex since it generates the highest profit but also incurs the higher losses in case of an unfavorable market. In case the project manager plans to minimize potential losses, the next alternative is to build the duplex since it will incur a lower loss due to an unfavorable market but also generates a lower profit. The third option of acquiring additional information increases the company expense but its value is that it will minimize decision risks. The reason for this is that the probability of the rental market being favorable or unfavorable can be predicted before deciding on building a duplex or quadplex. In case of a potential risk of loss for the other alternatives there is an alternative option or doing nothing and to look for a different investment project.
Figure 1. Decision table
Decision Making Under Uncertainty
There are five criterias of decision making under uncertainty but the resulting values developed into a mixed conclusion. The reason for this is that four of the five criterias resulted in a choice between building a quadplex or doing nothing depending on a perception of a favorable or unfavorable market. The last criteria chose the building of a duplex since it has the lowest opportunity loss value when compared to building a quadplex or doing nothing.
Figure 2. Uncertainty decision
Optimistic. The maximum earnings from each alternative is examined and the alternative with the highest earnings is chosen (Render et al., 2015, p.68). Figure 2 revealed that a maximum profit of $15,000 will be generated when building a quadplex. The alternative with the least advantageous is doing nothing since it will generate a profit of zero.
Pessimistic. The pessimistic criterion chooses the lowest earnings generated by each alternative in the investment project by considering that its consumer demand is at its worst (Render et al., 2015, p.69). The reason for this is that the project manager will expect for the worst case scenario especially in a volatile market such as the rental market industry. This means that the most favorable investment alternative is doing nothing since it generates a zero profit rather than incur additional company costs under building a quadplex or duplex alternative.
Criterion of Realism. The weighted average criterion considers both the optimistic and pessimistic points of view (Render et al., 2015, p.69). The reason is that companies will prepare for the worst possible business scenario but will hope for the best profit from the investments (Brealey, Myers and Allen, 2014, p.481). This is because companies are generally created for the purpose of generating profits for company owners except in the case of non-profit companies (Brealey, Myers and Allen, 2014, p.481). The coefficient of realism is estimated to be at 0.70, which resulted to a weighted average value between $4,500 to a negative $900. The alternative criterion with the highest and most realistic profit is to build the quadplex.
Equally Likely. The Laplace criterion averages the estimated payoff for each of the alternative investment choices (Render et al., 2015, p.70). The assumption is that the probability of generating the highest profit and incurring the greatest loss is equal (Render et al., 2015, p.70). However, the company still needs to generate better profits for its owners, which means that the chosen alternative must have the highest average value. In this case, the best alternative choice is doing nothing with a value of zero since the other alternatives was able to potentially incur losses of $2,500.
Minimax Regret. The opportunity loss criterion reveals the potential loss in profit for the company when choosing one alternative over another (Render et al., 2015, p.70). The reason for this is that the project manager will eventually regret choosing one alternative especially if the profit from the chosen alternative was lower than expected (Render et al., 2015, p.70). The initial step is to determine the opportunity loss for each alternative under the best and worst scenarios. The result of the criterion revealed that the highest potential for regret is not choosing building the quadplex since it will generate the highest profit. In this case the project manager will need to choose the lowest potential for opportunity loss, which is building the duplex at $10,000.
Expected Monetary Value
The potential decision of the construction project is expected to improve with the use of the expected monetary value formula (Render et al., 2015, p.71). This is because the project manager was able to improve the estimated payoff of each alternative based on a more accurate probability percentage (Render et al., 2015, p.71). When the project manager did not require the acquisition of additional information, the probability of a favorable rental market is estimated to be at 0.7. The resulting effect of this probability percentage is that building the quadplex will generate the highest potential profit for the company at $4,500.
Figure 3. EMV when no additional information was gathered
However, there will be 2 resulting values when the project manager requested for the additional information, which can generate either a favorable result or an unfavorable one. A favorable result will improve the probability percentage from the current 0.7 to 0.9 but the company will incur an additional cost of $3,000 for the additional information. This means that the company will incur an additional cost to all of the three alternatives resulting to a decrease in the potential profit and increasing the loss of each alternative choice under both a favorable and unfavorable market. The effect of a favorable result from the additional information is that the potential profit from building a quadplex improved to $8,500.
Figure 4. EMV with a favorable result from the additional information
The unfavorable result of the additional information improved the reliability of the probability percentage but it significantly declined to 0.4 under a favorable market. The company will still incur an additional cost of $3,000, which means that the company will decrease the potential profit and increase the expense/cost of each alternative choice by $3,000 under the favorable and unfavorable market. The effect of an unfavorable result from the additional information is that the potential profit was in actual fact a loss from all three alternative choices, which means that the best choice is doing nothing since it has the lowest value at $3,000.
Figure 5. EMV with an unfavorable result from the additional information
However the result of the additional information is believed to have a 50-50 chance of being favorable. This means that the value of the chosen alternative under a favorable and unfavorable result will be computed on a probability percentage of 0.5, as seen in figure 11 below. The resulting realistic profit value when additional information was acquired is at $2,750.
Figure 6. EMV from the additional information
Conclusion and Recommendation
The decision tree (under appendix a) and the exhaustive analysis using the formulas of decision making under uncertainty and risk revealed that the cost of the additional information resulted in a decline in profitability while increasing the costs to the company. The reason for this is that the potential for a favorable result based on additional information is significantly higher at 0.9 when compared to 0.4 for an unfavorable one. The effect of a favorable result from the additional information is that the company will generate a realistic profit of $8,500 when building a quadplex is chosen. The problem is that the risk of loss is also increased to $9,000 when building a duplex when compared to doing nothing at a cost of $3,000 under an unfavorable result. The probability of having a favorable result is perceived to be only 50% resulting to a potential realistic profit of $2,750 with the use of additional information.
The realistic profit of not acquiring additional information is estimated to be at $4,500, which was significantly lower than the realistic profit of $8,500 from a favorable result of additional information. The $4,500 realistic profit is perceived to be significantly better when compared to a potential loss of $9,000 under building a quadplex or doing nothing at a cost of $3,000 under an unfavorable result of additional information. The decision tree revealed that it is better not to rely on the additional information especially with the higher cost of $3,000. The decision tree further revealed that the best option is still to build the quadplex while minimizing company costs by using no additional information.
References
Brealey, R. A., Myers, S. C. and Allen, F. (2014). Principles of corporate finance (11th ed.). New York, NY: McGraw-Hill Irwin.
Render, B., Stair, R., Hanna, M. E., and Hale, T. S. (2015). Quantitative analysis for management (12th ed). United Kingdom: Pearson Education Limited.
Appendix A. Decision tree
Appendix B. Maximax decision
Appendix C. Minimax decision
Appendix D. Criterion of Realism
Appendix E. Equally Likely/Laplace Criterion
Appendix F. Minimax Regret
Analytical Experience and Plans
Personal experience in the use of analytical methods is considered to be only moderate due to the fact that there are multiple quantitative and qualitative methods that are available to decision makers. Some of the quantitative methods include decision trees under TreePlan, Risk and Sensitivity Diagrams under Power Pivot in Excel and Scenario Analysis with Excel’s Scenario Manager. However, based on the problem the most applicable method to be used in analyzing a building investment is the decision tree under TreePlan. The reason for this choice is that the problem requires the project manager to either build a quadplex, build a duplex or to do nothing.
With regards to the problem, there was some initial confusion with regards to the alternative options given. This is because the problem included the decision to acquire additional information as part of the alternative choices of the project manager. The further examination of the theory behind decision trees resulted in a more relevant examination of the proposed investment project. This means that the initial four alternative options was only actually three, which are: (1) building a quadplex, (2) building a duplex, and (3) doing nothing.
The result of this examination revealed that there is an initial decision, which is either to make use or not make use of acquiring additional information. Under the acquisition of additional information there is another decision, which is to examine the investment under a favorable and an unfavorable market. This means that there are actually three decision segments, which are to (1) examine the investment without using additional information, (2) examine the investment under a favorable market with additional information, and (3) examine the investment under an unfavorable market with additional information. The resulting values under the decision segments will be used to facilitate and enhance the decision of the project manager.
