Special Revision Session – Paper 02

Decision Theory
CL3 – Advanced Management Accounting

Question No 01
HPL is a fruit drink manufacturing company which has established in
Katunayake. Company has identified 2 target markets and evaluating on which
market to be catered. The expected annual market demand would be High,
medium and Low with following probabilities.
Colombo Gampaha
Market Probability Demand Probability Demand
Condition Units Units
High 30% 100,000 20% 90,000
Medium 50% 50,000 40% 60,000
Low 20% 20,000 40% 30,000

The selling price per unit will be Rs. 60/- and the variable cost will be Rs. 40/-
per unit. The annual fixed cost will be Rs. 500,000/-.
Required
Prepare a payoff table and determine the most feasible market based on,
i. Maximax decision Rule
ii. Maximin decision Rule
iii. Expected Value Criterion

Question 02
Following information are relevant to 3 projects which are currently evaluating
by the Alpha PLC. The expected net cashflows for the 3 projects with the
different economic conditions are as follows.
Net Cash Flows (Rs. Millions)
Econmic Condition Project A Project B Project C
Favourable 100 120 150
Most likely 80 60 40
Adverse 20 10 -10
Determine the best project under following decision-making criteria,
1. Maximax rule
2. Maximin rule
3. Minimax regret rule

Question 03
Dunhill PLC is expecting to launch a new product and they are considering
whether company should do a market research or not. If company test the
market the result will be either positive or negative with the probability of 60%
and 40% respectively.
If the result of the research is positive, company will sell the product with full
scale and demand conditions will be High, Medium and low with the probability
of 60%,20% and 20% respectively. The expected profit under high, medium
and low demand conditions would be Rs. 100 mn, Rs. 60 Mn and Rs. 20 mn
respectively. The cost of doing a market research would be Rs. 5 Mn.
If the result of the research is negative, company can decide either abandon the
product or sell it full scale. If product being abandoned, the residual of the
investment can be sold at a disposal value of Rs. 5 Mn. If company decided to
sell in full scale the expected loss would be Rs. 10 Mn.
Company has an alternative option to sell the product through an international
agent which the agent will charge Rs. 10 Mn as a commission. Then entity need
not to do a market research. The market demand would be High, medium and
low with the respective probability of 50%,30% and 20%. The expected profit
under High, low and medium will be Rs. 100 Mn, Rs.60 Mn and Rs. 30 Mn.

Required
a. Draw a clearly labelled decision tree
b. Decide the best course of action when launching the new product of
Dunhill PLC.
Question 04
Mega Development Builders (Pvt) Ltd (MDB) is a large scale infrastructure
development company with a reputation for delivering quality output. With the
launch of the Megapolis concept, MDB has envisaged opportunities for large
scale infrastructure projects.The government has lined up two large projects,
EXE and WYE, which MDB is interested in.

The request for proposal (RFP) has been issued for EXE. The RFP for WYE will
be issuedlater, after appointing the contractor for project EXE. Based on past
practice in relation to government tenders, MDB is aware that if it could secure
project EXE, there is a better chance of securing project WYE.

The quantity surveyors of MDB have come up with the initial estimates for EXE
with normal prices, according to which the suggested contract value is Rs. 2,000
million with a net profit margin of 15%. Per information available, the
estimated value of project WYE is Rs. 3,000 million. If MDB can secure EXE, then
with the experience of that project it can earn a net profit margin of 20% on
WYE and otherwise it will be 15%.

The management of MDB is of the view that if they quote Rs. 2,000 million for
EXE, the chance of winning the project is 60%, whereas if the quoted price is
reduced by 10%, the chance of winning the project would increase to 80%. In
the event MDB quotes the lower price it will undertake a rigorous cost saving
plan by which it intends to reduce the total cost of the project by Rs. 100 million.

If MDB wins project EXE, it will not consider any price reduction when bidding
for project WYE. The probability of MDB winning both projects in that event is
48%. However if MDB fails to win project EXE it has an option to consider a
price reduction of 10% for project WYE, enhancing its chance of winning the
project to 50% which would otherwise have been 40%. In the case of project
WYE, there is no possibility of any cost saving.

Required:

(a) Assess the following probabilities:

(i) The probability of winning the project WYE after winning EXE, having
quoted EXE at the normal price
(ii) The probability of losing the project WYE after winning EXE, having
quoted EXE at the normal price
(iii) The probability of winning the project WYE after winning EXE, having
quoted EXE at the reduced price
(iv) The probability of losing the project WYE after winning EXE, having
quoted EXE at the reduced price
(b) Outline the options available for MDB in a decision tree, clearly showing
the decisions to be made, outcomes and related probabilities.
(11 marks)
(c) Recommend the best course of action for MDB in quoting for projects EXE
and WYE. (Hint: Evaluate the decision tree based on expected values using the
backward evaluation method)
(10 marks)
(2017 June Q 07 - Total: 25 marks)

Question 05
Research Department of Creamy Cheese Manufacturers (CCM) has developed a
high quality recipe for cheese. A wholesaler has proposed to buy CCM’s entire
production of 100,000 packs at Rs. 600 per pack provided CCM makes a
commitment now.

(A) CCM is currently negotiating with an overseas party which has a well
known brand name for cheese to market its new variety of cheese
under that brand name. However it will take some time to reach a
conclusion on such negotiation.
(B) CCM has also received information that a competitor is also planning
to introduce a similar high quality variety of cheese. If the competitor
introduces his product in the market, then it will have an impact on
the price at which CCM could sell the product.
The intention of CCM at the moment is to focus on the market acquisition and
therefore concentrate on the revenue rather than profit.
The management of CCM has formulated the possible outcomes and the price
at which they could market the product as follows:
O1- No competitive product and CCM gets the new brand name – Rs. 680 per
pack

O2 - No competitive product but CCM doesn’t get the new brand name – Rs.
640 per pack

O3 - Competitive product introduced and CCM gets the new brand name – Rs.
600 per pack

O4 - Competitive product introduced and CCM doesn’t get the new brand
name – Rs. 320 per pack

Management of CCM has identified three possible strategies they could adopt
which are given below.

S1 - Commit to the wholesaler for the 100,000 packs to be sold at Rs. 600 per
pack.
S2 - Sell the entire production of 100,000 packs after the outcomes of A and B
are known.
S3 - Commit to the wholesaler for 50,000 packs (assume the wholesaler is
agreeable to purchase this quantity at Rs. 600 per pack) and sell the balance
50,000 packs once the outcomes of A and B are known.

You are required to:

(a) Draw up a payoff table for CCM and determine the solution based on
(i) Maxi – Min Rule
(ii) Maxi – Max Rule
(iii) Min – Max Regret Rule (8 marks)

(b) Briefly explain the underlying principle(s) of the three rules given in (a)
above. (2 marks)
(c) It has been estimated that the probability of competitor introducing his
product is 55% and that there is a 65% chance that CCM will get the new brand
name. Determine the optimum policy for the company using the criterion of
maximizing expected pay off. (5 marks)
(d) Determine the expected value of perfect information for CCM.
(3 marks)
(2013 June – Q 04)