Question

Newfoundland Energy System

In the early 2000s, Newfoundland Energy System (NES) was deciding how much to bid for the salvage rights to a grounded ship, the SS Klondike. If the bid were successful, the ship could be repaired and outfitted to haul coal for the company’s power-generation stations. But the value of doing so depended on the outcome of a U.S. Coast Guard judgment about the salvage value of the ship.

The Coast Guard’s judgment involved an obscure law regarding domestic shipping in coastal waters. If the judgment were to indicate a low salvage value (an outcome with an estimated 30 percent chance of occurring), and if NES submitted the winning bid, then NES would be able to use the ship for its shipping needs without additional costs. If the judgment were high, the cost to NES would run $4 million higher than if the judgment were low. The Coast Guard’s judgment would not be known until after the winning bid was chosen, so there was considerable risk associated with submitting a bid.

If the bid were to fail, NES could purchase either a new ship or a tug/ barge combination, both of which were relatively expensive alternatives. Analysts at NES estimated that purchasing a new ship for these purposes would lead to profits of $3.2 million (calculated as a net present value over 20 years of shipping). Purchasing a tug/barge combination would lead to profits of only $1.6 million.

By comparison, if NES could acquire the Klondike at the lower salvage value it could achieve profits of $15.5 million, exclusive of its bid.

One of the major issues was that the higher the bid, the more likely NES would be to win. NES judged that a bid of $2 million would definitely not win, whereas a bid of $12 million definitely would win. A bid of $8 million would have a 60% chance of winning.

Draw a decision tree for this situation and answer the two questions below.

How should NES bid if its objective is to maximize its profits from supplying coal to its plants?

Suppose that NES has access to inside information on how the Coast Guard will decide on this case – low or high salvage value. What is the most it should be willing to pay for this information?