James, Inc., a large mail-order catalog firm, is thinking of expanding into Canada. The Buffalo district office would manage the expansion and must decide how much to spend on the advertising campaign. The expansion project will be either successful (S) or unsuccessful (U). The probability of success depends on the amount spent on the advertising campaign. If the project is successful, the gross profit (before advertising) is $1.4 million. If the project is unsuccessful, the gross profit (before advertising) is $100,000. The accompanying table lists how the probability of success varies with the amount of spending on the Canadian venture.
| Amount of Advertising (000s) | Gross Profit (000s) | ||
| Probability of Success (S) | If Successful | If Unsuccessful | |
| $ 10 | 0.20 | $1,400 | $100 |
| 25 | 0.21 | 1,400 | 100 |
| 40 | 0.22 | 1,400 | 100 |
| 55 | 0.23 | 1,400 | 100 |
| 70 | 0.24 | 1,400 | 100 |
| 85 | 0.25 | 1,400 | 100 |
| 100 | 0.26 | 1,400 | 100 |
| 115 | 0.27 | 1,400 | 100 |
| 130 | 0.28 | 1,400 | 100 |
| 145 | 0.29 | 1,400 | 100 |
James, Inc., is a publicly traded firm and its senior managers and shareholders wish to maximize expected net cash flows from this venture. The Buffalo manager receives a bonus of 10 percent of the net profit (gross profit less advertising).
The bonus is paid only if the firm has gross profit net of advertising. If gross profit less advertising is negative, no bonus is paid. The manager wants to maximize her bonus and has private knowledge of how the probability of success varies with advertising.
Required:
a. What advertising level would senior managers choose if they had access to the Buffalo manager’s specialized knowledge?
b. What advertising level will the Buffalo manager select, knowing that senior managers do not have the specialized knowledge of the payoffs?
c. If the advertising levels in (a) and (b) differ, explain why.
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