Question

Can anyone help me with this exercise?Thank you

Exercise on decision tree You need to decide to choose one location for a residential building. Use decision tree to make decision. Annual revenue High demand Low demand Project Investment Large $150,000 $90,000 $100,000 $50,000 $10,000 $20,000 Small Forecasting probabilities of demand: • High demand in 10 years: 25% • Low demand in 10 year: 25% • High demand in 02 year, and low demand in 08 year: 50%

Answer 1

As peer decision tree approach, we will calculate expected monetary value (EMV) for each of the projects based on payoff value and probabilities.

EMV = Σ Payoff value_i* Probability_i

Project: Large

EMV (Large) = - Initial investment + ((High demand payoff*Number of years* Probability of high demand for 10 years)+ (Low demand payoff*Number of years* Probability of Low demand for 10 years) + ((High demand payoff for 2 years*Number of years + Low demand payoff for 8 years*Number of years)*(Probability of high demand for 2 years and low demand for 8 years))

EMV (Large) = - $150,000 + ($100,000*10*25% + $10,000*10*25% + ($100,000*2+$10,000*8)*50%)

EMV (Large) = $265,000

Project: Small

EMV (Small) = - $90,000 + ($50,000*10*25% + $20,000*10*25% + ($50,000*2+$20,000*8)*50%)

EMV (Small) = $215,000

EMV (Large) is higher than EMV (Small).

Hence, "Large" project location for a residential building should be chosen.

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