MS&E 352 Decision Analysis II ____________________________________________________________________________________________

MS&E 352 Final Examination (Winter 2012)

Distributed: Thursday, March 15th, 2012 at 5:00pm Due: Wednesday, March 21st, 2012 at 5:00pm Please Note: Please copy the Honor Code statement below into the document you submit as a record of your digital signature. No exams will be accepted after the due date and time. Late submission of the final exam will result in a grade of 0/300.

1. This exam is a take-home exam. You may use the reference material listed in the course guide as well as any work that you have done during the quarter. Please do not refer to any work done by students of previous years. This is meant to be an individual effort; you should not discuss this exam with anyone except the teaching team. We encourage you to use a calculator or a spreadsheet program where needed. 2. Read over each question carefully. You may not need all the information given in a particular problem. 3. On the title page, please write out your full name under the Honor Code. Your exam will not be graded unless you have typed your full name and the Honor Code on the title page. Please submit your final exam solutions via Coursework. Note: If you plan to submit two separate files (e.g. one .doc and one .ppt) then please make sure that you paste the signed honor code on the first page of both documents. 4. Unless stated otherwise, the characters in the exam prefer more money to less and follow the Five Rules of Actional Thought. Do not make any additional assumptions. 5. Please include a general table of contents for the work that you turn in. 6. If you have any questions, please post them to the Coursework Discussion page. Only if you feel that your question will reveal a substantive part of the solution should you email a TA. 7. Clearly show your work. You will not receive credit for illegible work or if you do not show your work. Partial credit will be given where appropriate. For problems with numerical answers, please draw a box around, or otherwise highlight the final answer. 8. The exam is worth a total of 300 points. The points are broken down by question.

In recognition and in the spirit of the Honor Code, I certify that I will neither receive nor give unpermitted aid on this exam and that I will report, to the best of my ability, all Honor Code violations observed.
Name (printed): _______________________________________________

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Problem 1 Auctions (50 points)

PART I Billionaire Art Lovers (20 points)
You work for Bill G., an eccentric risk-neutral billionaire art lover, who is considering entering a sealed-bid, first-price auction for a classy painting. The value of the painting to Bill G. is independent of the bid amount. After much thoughtful analysis, you have constructed two graphs that provide insight into Bill G.s bidding situation. Unfortunately, the numbers on the x-axis of one of the graphs have been erased. All you can be sure of is that you have done your analysis correctly. Here are the graphs (please note that the two graphs might have different horizontal scales):
Probability Bill G. Acquires Painting vs Bid
1.0 0.9 0.8

{Bill G. Acquires Painting|Bid,&}

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

Bill G.'s Bid Amount

Certain Equivalent of Bill G.'s Bid Deal vs Bid Amount

8 6 Certain Equivalent ($K) 4 2 0 -2 0 -4 -6 -8 -10 -12 Bill G.'s Bid Amount ($K) 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40

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Please answer the following questions, providing a one or two sentence explanation for each one. (For full credit, numerical answers should be within $1000 of actual values.)

a) [5 points] What is Bill G.s optimal bid? b) [5 points] What is the minimum that Bill G. must bid to be virtually certain that he will acquire the painting? c) [5 points] For reasons known only to him, Warren B. wants to keep Bill G. from participating in this auction. He is willing to pay him not to participate. What is the minimum payment that Bill G. would accept to refrain from participating in the auction? d) [5 points] Warren B. decides not to make the payment discussed in (c), and Bill G. acquires the painting in the auction. Now Warren B. wants to buy the painting from Bill G. What is the minimum payment that Bill G. would accept to sell the painting?

PART II A Quick $100 (30 points)

You are about to bid for a certificate which entitles its owner to an uncertain deal. You believe that this uncertain deal is a lucrative opportunity if you acquire the certificate, you will have a 80% chance of winning $100, and a 20% of winning $0. Unfortunately you are not sure how many other people will bid for the lottery ticket, and you are also unsure how those people will bid. You wish to follow the delta property in the range of the prospects described in this problem, and estimate your risk aversion coefficient to be equal to 0.001.

a) [15 points] In this part, assume that there are N people bidding against you in this first-pricesealed auction. Each of them will place a bid distributed according to a Beta distribution with parameters r = 6, n = 12 on the range $0-$100 (i.e. the distribution has a mean of $50). You believe that all N bids are irrelevant to one another given &. For N = 1, N = 2, and N = 3, compute: The optimal bid amount; Certain Equivalent given the optimal bid; The probability of acquiring the certificate at the optimal bid amount. Conclude what do you think will happen as N increases? How would you explain this?

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b) [15 points] In this part, assume that there is only one person bidding against you. This person will place a bid distributed according to a Beta distribution with parameters r, n = 2r on the range $0-$100 (i.e. the distribution has a mean of r/n). For r = 1, r = 6, and r = 20, compute: The optimal bid amount; Certain Equivalent given the optimal bid; The probability of acquiring the certificate at the optimal bid amount. Conclude what do you think will happen as r increases? How would you interpret this result, and how would you explain it?

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Problem 2 What Can Go Wrong in a Sensitivity Analysis (50 points)

Crazy Widgets, a risk-neutral company, faces what they believe to be an interesting investment opportunity. They can either invest or not invest in a new market. The size of this new market is 10 million units, and Crazy Widgets would sell their goods at a unit price of $21. Unfortunately they believe their market share and unit cost to be uncertain; after a long meeting with some of their key executives, you have been able to assess the probability distribution shown on the next page. Crazy Widgets computes profit as market size * market share * (unit price unit cost); therefore, their profit is not directly influenced by oil price but they still believe that this is a useful and relevant distinction when thinking about their market share and unit cost. Assume that the value of not investing is $0, and compute all relevant quantities in millions of dollars. a) [10 points] Draw a Tornado Diagram for the Invest alternative, using the uncertainties Oil Price, Market Share and Unit Cost. b) [5 points] Comment on this tornado diagram what are its two major flaws in capturing what goes on in this decision problem? Suggest ways to fix the diagram and remediate these two flaws (you do not need to act upon your recommendations; just explain what you would do to resolve these issues). c) [10 points] Draw an open loop closed loop chart for the Oil Price uncertainty. Does this address some of the issues raised in part b)? Why or why not? d) [25 points] Draw an open loop closed loop chart for the Market Share uncertainty, and another open loop closed loop chart for the Unit Cost uncertainty. Does this address some of the issues raised in part b)? Why or why not?

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Unit Cost of $20 Market Share at 40% 0.25 Unit Cost of $18 0.8 0.2

Unit Cost of $23 0.2 Stable Oil Price Market Share at 20% 0.6 0.5 0.6 Unit Cost of $20

Unit Cost of $18 0.2

Unit Cost of $23 Market Share at 10% 0.25 Unit Cost of $20 0.2 0.8

Unit Cost of $23 0.2

Market Share at 40% 0.25

Unit Cost of $20 0.6

Unit Cost of $18 0.2

Unit Cost of $23 0.7 Increase in Oil Price 0.4 Market Share at 20% 0.5 Unit Cost of $20 0.2

Unit Cost of $18 0.1

Unit Cost of $23 Market Share at 10% 0.25 Unit Cost of $20 0.1 0.9

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Problem 3: (200 points) Case Study Large Instrument Manufacturer, Inc.

1) Problem Statement:
Large Instrument Manufacturer, Inc. (LIM) is the producer of the ROE-1, a sophisticated research instrument. The government of UDC is among those that have purchased several ROE1s. Two years ago, UDC bought the ROE-1s for $77,000 each and installed them throughout the country. Unfortunately, UDC has had difficulties maintaining the proper operation of the ROE-1s. LIMs management has learnt a painful lesson from the large loss associated with the sale of ROE-1s to UDC. As a result, in reviewing the business plan for the ROE-2 (the follow-up version of the ROE-1), which will be sold to UDC in 2011, LIM is considering several servicing alternatives: The first alternative is to continue with the present servicing arrangement. This means that LIM itself must send trained service personnel to UDC. The next alternative is to train UDC engineers so they can repair the machines on their own. However, since the user cannot repair all breakdowns, LIM would still have to send its service personnel to UDC periodically. LIM can also sign a contract with IPX, an independent service firm. The contract would cover any type of breakdown that might occur. Finally, LIM can choose not to sell any ROE-2s to UDC. LIMs warranty period is limited to five years (covering 2011-2015). Any breakdowns that occur beyond the warranty period must be repaired at the expense of the purchaser. All ROE-2 sales would occur in 2011 but not after that, since LIM is planning to introduce the revolutionary ROE-3 in just a year. Finally, LIMs CEO has instructed you to use a 2.75% discount rate and to assume riskneutrality (at least in the first pass of your analysis). The sales price of the ROE-2 is $100,000. The cost of manufacturing, marketing, and installing an ROE-2 is $70,000.

2) Uncertainties and Additional Assumptions:

LIMs experts have carefully thought about a few uncertain variables: the number of machines LIM can sell to UDC in 2011; the average service cost per machine per year during the five year warranty period which depends on the servicing alternative selected; the training cost per machine sold. All machine failures are of one of two types: alpha or beta. The percentage of machines per year that will experience an alpha or beta failure is uncertain. The average costs for LIM to repair alpha and beta failures are two more uncertainties. If the train for self-maintenance servicing alternative is selected, LIM will only be liable for alpha failures. However, it will have to include a supply of parts and servicing equipment with
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each unit sold and train the users to fix beta failures. The training would be offered to UDCs engineers in the first year (2011). The parts and servicing equipment per machine sold would be bought by UDC in 2011 as well, and would cost $9,000 per unit sold (in 2011 only and paid by LIM). If the service contract is signed, LIM will pay IPX $750,000 or 23% of the sales price for every ROE-2 sold in UDC during the next year, whichever is greater. This one-time payment would occur in 2011. Of course, LIM could also decide not to sell ROE-2s to UDC. Since this would adversely impact the sales of LIMs other products, LIM considers the loss associated with this alternative to be $8,000 (expressed in 2011 dollars). LIM's experts have given the following rough assessments of the six primary uncertainties:
Description Repair cost uncertainties Avr repair cost, alpha failure Avr repair cost, beta failure Alpha failures per year Beta failures per year Revenue uncertainties Number of machines sold Training costs uncertainties Training cost per machine Low Base High

$ thousand $ thousand fract of machines fract of machines

9.0 7.1 0.12 0.64

10.0 8.0 0.15 0.70

12.0 9.4 0.19 0.75

units

25

30

50

$ thousand

4.0

8.0

12.0

The end of this handout shows the detailed assessments of these uncertainties which LIMs experts would give you if asked. We will not take tax into account for this case study.

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3) Your Task:
You are to prepare a Powerpoint presentation aimed at a reader who is well-versed in Decision Analysis, showing your work through one iteration of the Decision Analysis cycle for LIMs decision problem. Your report should comprise the following: A table of contents / agenda in which you will identify key parts of your analysis; Presentation slides showing the insights you gathered from the use of the Decision Analysis tools. Please place each concept or tool on a separate slide, and structure your report in the order shown on the Decision Analysis Cycle (Formulation Evaluation Appraisal). Please do not use more than 20 slides; if your report exceeds this limit you will be penalized for doing so (the 20 slides limit does not include the title page or the table of content). You may include a few more slides beyond the 20-slide limit as an appendix, especially slides showing your trees and calculations in a more detailed manner, but please be aware that they may only influence your grade if we wish to award partial credit for an analysis in which you made a mistake. Please make sure that all the necessary inputs of your model (e.g. the discretized distribution of key uncertainties) are neatly organized in your appendix so that we can easily crosscheck your numbers. Please try to include some slides in the appendix to back up your results as well (e.g. probabilistic dominance analysis). Last, here are some important remarks that we hope will guide you in your analysis: Rely on Tornado Diagrams Six uncertainties is already a respectable amount of complexity, and we do not want you to draw a tree with 729 branches. Instead, use tornado diagrams to identify, for each alternative, the uncertainties which cover 95% of the variance or more. Once you have identified the critical uncertainties, you are allowed to reassess their low base high values using the distributions we are providing. Please discretize those distributions using the equal areas method or the equal areas shortcut method, and show on one of your slides (within the appendix) the end results of those discretizations. You can then use those critical uncertainties to build a probabilistic tree which will help you plot the CDF of each alternative. This CDFs plot should have a step shape since its based on the discretized distributions. There is no need to smooth out this CDFs plot by interpolation. Please note that for each alternative, some of the critical uncertainties might not need to appear in your tree at all, because they do not affect that particular alternative. Insist on your Insights Build a model to translate the problem statement into math. Then do the analysis. Then translate the numbers back into English and burn the math Each time you present a Decision Analysis tool, insist on the insights you are able to derive from it never show analysis just for the sake of analysis.

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Appraisal is Essential During the Appraisal phase you should state on which part of the analysis you would focus next. How would you modify your model? What information would you recommend LIM gather? Which assumptions would you question? What new ideas and alternatives would you suggest and explore? Etc.

6) Additional Remarks & Contact Information:

The objective of this assignment is obviously NOT to test your skills at building financial value models. Therefore, we will provide you with a few numbers to allow you to cross-check your own results as soon as you are finished building your deterministic value model, please go to the class website, download the available value model template and carefully check your numbers. Please also note that this template consists of not just one worksheet, but two. Finally, be reminded that you should not assume that any of the distributions provided as expert assessments are normal. If you have any questions regarding this part of the final exam, please post it on the coursework forum. We hope you find this case a good learning experience. Good luck and clear insights!

The DA2 Teaching Team

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Appendix - Cumulative Distributions on the Uncertainties:

Avr repair cost, Alpha failure
100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% $8.0

$9.0

$10.0

$11.0 $ thousand

$12.0

$13.0

$14.0

Avr repair cost, Beta failure

100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% $6.00

$6.50

$7.00

$7.50

$8.00

$8.50 $ thousand

$9.00

$9.50

$10.00

$10.50

$11.00

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Alpha failures per year

100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

Fraction of machines

Beta failures per year

100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 55.0%

60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

Fraction of machines

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Number of machines sold

100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 20 25 30 35 40 Units 45 50 55 60

Note: Please assume that fraction of machine can be sold

Training cost per machine

100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 0 2 4 6 8 $ thousand 10 12 14 16

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