EXPECTED VALUE QUESTIONS

Example 1
Olayemi Ltd expects the following monthly profits:
Monthly profit Probability
N50,000 0.6
N35,000 0.4

Required:
Calculate the expected value of monthly profit.

Example 2
Consider the following sales and probabilities.
Sale Probabilities
N %
20,000 25
25,000 40
30,000 15
35,000 20

Required:
What will be the expected value?

Example 3
Suppose that there are two mutually exclusive projects with following possible payoffs
Project A Project B
Probability Monthly Profit Probability Monthly Profit
N N
0.8 5,000 0.1 (2,000)
0.2 6,000 0.2 5,000
0.6 7,000
0.1 8,000
Required
Determine which project should be chosen

DECISION TREE QUESTIONS

Example 4
The following information relates to Abimbola Ltd, a company which is considering whether to develop
and market a product.
Probability
Development
Being successful 0.75
Being unsuccessful 0.25

Estimated development costs would be N180,000

If successful, the product will be marketed with following probabilities:

Probability Profits / (Loss)
Being very successful 0.4 N540,000
Being moderately successful 0.3 N100,000
Being failure 0.3 (N400,000)

The above profits / losses figures include the effect of the development costs.

Required:
Draw a decision tree to illustrate the above problem, and recommend the best course of action.A
R
Example 5
A software company has just won a contract worth N160, 000 if it delivers a successful product
on time but only N80, 000 if this is late. It faces the problem on whether to produce the work in
house or to sub contract it. To subcontract the work would cost N100,000 but the local sub-
contractor is so fast and reliable as to make it certain that successful software is produced on
time.

If the work is produced in-house, the cost would be only N40,000 but based on past experience,
would have only 90% chance of being successful. In the event of the software not being
successful, there would be insufficient time to re-write the whole package internally but there
would still be the options of either a late rejection of the contract(at a further cost of (N20,000) or
of late sub-contracting the work on the same term as before. With this late start, the local sub-
contractor is estimated to have a 50/50 chance of producing the work in time or producing it
late. In this case, the sub-contractor still has to be paid N100,000 regardless of whether he
meets the deadline or not.

You are required:

a. to draw a decision tree for the software company using squares for decision point and circles
for chance points including all relevant data on the diagram.

b. to calculate expected values as appropriate and to recommend a course of action to the

software company.

Example 6
Hadex Limited has a new wonder product of which it expects great things. At the moment, the
company has two courses of action open to it: to test-market the product or abandon it.
If the company test markets it, the cost will be N100,000 and the market response would be
positive or negative with probabilities of 0.60 and 0.40.

If the response is positive, the company could either abandon the product or market it full scale.
If it markets the product full scale, the outcome might be low, medium or high demand and the
respective net gains/(losses) would be (N200), N200 or N1000 in units of 1,000 (the result could
range from a net loss of N200,000 to a gain of N1,000,000). These outcomes have probabilities
of 0.20, 0.50 and 0.30 respectively.

If the result of the test marketing is negative and the company goes ahead and markets the
product, estimated losses would be N600,000.
If, at any point, the company abandons the product, there would be a net gain of N50,000 from
the sale of scrap. All the financial values have been discounted to the present value.

You are required to:

a. draw a decision tree to illustrate the above scenario
b. advise the company on the option to be selected.
THE VALUE OF PERFECT AND IMPERFECT INFORMATION

Example 7
The management of Itesiwaju Ltd must choose whether to go ahead with either of two mutually
exclusive projects, A and B. The expected profits are as follows.
Profit if there is Profit if there is Profit/(loss) if there is
strong demand moderate demand weak demand

Option A N4,000 N1,200 (N1,000)

Option B N1,500 N1,000 N500

Probability of demand 0.2 0.3 0.5

Required
(a) Ascertain what the decision would be, based on expected values, if no information about
demand were available.

(b) Calculate the value of perfect information about demand.

Example 8
WL must decide at what level to market a new product, the urk. The urk can be sold nationally,
within a single sales region (where demand is likely to be relatively strong) or within a single
area. The decision is complicated by uncertainty about the general strength of consumer
demand for the product, and the following conditional profit table has been constructed.
Demand
Weak Moderate Strong
N N N
Market nationally (A) (4,000) 2,000 10,000

in one region (B) 0 3,500 4,000

in one area (C) 1,000 1,500 2,000

Probability 0.3 0.5 0.2

Required
Option B should be selected, based on EVs of profit. True or false?

Example 9
Using the information in your answer to the question(8) above (decision based on EV of profit)
calculate the value of perfect information about the state of demand.

Example 10
If the cost of obtaining perfect information is N400 using the information in your answer to the
questions 8 and 9, draw up the decision tree to represent the information and take the decision.
Example 11
Suppose that a company want to make a decision between two mutually exclusive options,
Option A and Option B. the profits from each option will depend on the state of the economy in
the next 12 months.

Current estimates are that there is a 60% probability that the economy will be weak and a 40%
probability that the economy will be strong.
The profitability with each decision option would be as follows.

Option A Option B
Weak economy + N50,000 + N20,000
Strong economy + N60,000 + N100,000

Research could be carried out into the state of the economy in the next 12 months. It has been
estimated that if the true state of the economy will be weak, there is an 80% probability that the
research would predict this correctly. It is also estimated that if the true state of the economy will
be strong, there is an 90% probability that the research would predict this correctly.

Required
What is the value of this imperfect information?

Example 12
Suppose that the Small Oil Company (SOC) is trying to decide whether or not to drill on a
particular site. The chief engineer has assessed the probability that there will be oil, based on
past experience, as 20%, and the probability that there won't be oil as 80%.

It is possible for SOC to hire a firm of international consultants to carry out a complete survey of
the site. SOC has used the firm many times before and has estimated that if there really is oil,
there is a 95% chance that the report will be favourable, but if there is no oil, there is only a 10%
chance that the report will indicate that there is oil.

The cost of drilling is N10m. The value of the benefits if oil is found is N70m giving a net profit of
N60m and the cost of obtaining information from the Consultants would be N3m.

Required
Determine whether drilling should occur. FORWARD

SENSITIVITY ANALYSIS QUESTIONS

Example 13
Bodija Ltd has estimated the following sales and profit for a product which it may launch onto
the market.
N N
Sales (2,000 units) 4,000
Variable costs:
Materials 2,000
Labour 1,000
3,000
Contribution 1,000
Incremental fixed costs 800
Profit 200
Required:
(a) Analyse the sensitivity of the product.
(b) Determine which of the variables is the product most sensitive.ensitivity

Example 14
Funsho has just set up a company, Fulfillment manufacturing Plc and estimated cost of capital
to be 15%. His first project involves investing in N150,000 for equipment with a life of 15years
and a final scrap value of N15,000.

The equipment will be used to produce 15,000 deluxe pairs of rain boots per annum generating
a contribution of N2.75k per pair. He estimates that annual incremental fixed costs will be
N15,000 per annum.

a. Determine on the basis of the above figures, whether the project is worthwhile and
b. Calculate the sensitivity of your calculations to:
i. Initial Investment;
ii. Annual Sales volume
iii. Annual incremental fixed costs
iv. Scrap value
v. Cost of capital
By finding what percentage changes in the above figures would cause your decision in (a) to
change.

Example 15
Shooting Star Plc is considering investing in a new manufacturing facility with the following
characteristics
a. Initial investment N350,000 scrap value Nil
b. Expected life of ten years
c. Sales Volume 20,000 units per year
d. Selling price N20 per unit
e. Variable Direct costs N15 per unit
f. Annual Incremental Fixed Cost excluding depreciation N25,000 p.a.
The project shows an Internal Rate of Return (IRR) of 17%. The MD is concerned about the
viability of the investment as the return is close to the company’s hurdle rate of 15%.He has
requested a sensitivity analysis.
You are required to:
a. determine the contribution / Unit which will bring the NPV to Zero.

b. recalculate by how much each of the characteristics (a) to (f) above could, in isolation, vary
adversely before the project failed to earn a return of 15% .

c. advise the MD of the most vulnerable area likely to prevent the project from meeting the
company’s hurdle rate.

d. re-evaluate the situation if another company already manufacturing similar product offered
to supply the units at N18 each, this would reduce investment required to N250,000 and
annual incremental fixed cost to N10,000.