The Value of Information

Scenario: Usin" rel="nofollow">ing the same situation from the Module 3 SLP, recall that you are decidin" rel="nofollow">ing among three in" rel="nofollow">investments. You have heard of an expert who has a highly reliable “track record” in" rel="nofollow">in the correct identification of favorable vs. unfavorable market conditions. You are now considerin" rel="nofollow">ing whether to consult this “expert.” Therefore, you need to determin" rel="nofollow">ine whether it would be worth payin" rel="nofollow">ing the expert’s fee to get his prediction. You recognize that you need to do further analysis to determin" rel="nofollow">ine the value of the in" rel="nofollow">information that the expert might provide. In order to simplify the analysis, you have decided to look at two possible outcomes for each alternative (in" rel="nofollow">instead of three). You are in" rel="nofollow">interested in" rel="nofollow">in whether the market will be Favorable or Unfavorable, so you have collapsed the Medium and Low outcomes. Here are the three alternatives with their respective payoffs and probabilities. Option A: Real estate development. This is a risky opportunity with the possibility of a high payoff, but also with no payoff at all. You have reviewed all of the possible data for the outcomes in" rel="nofollow">in the next 10 years and these are your estimates of the Net Present Value (NPV) of the payoffs and probabilities: High/Favorable NPV: $7.5 million, Pr = 0.5 Unfavorable NPV: $2.0 million, Pr = 0.5 Option B: Retail franchise for Just Hats, a boutique-type store sellin" rel="nofollow">ing fashion hats for men and women. This also is a risky opportunity but less so than Option A. It has the potential for less risk of failure, but also a lower payoff. You have reviewed all of the possible data for the outcomes in" rel="nofollow">in the next 10 years and these are your estimates of the NPV of the payoffs and probabilities. High/Favorable NPV: $4.5 million, Pr = 0.75 Unfavorable NPV: $2.5 million, Pr = 0.25 Option C: High Yield Municipal Bonds. This option has low risk and is assumed to be a Certain" rel="nofollow">inty. So there is only one outcome with probability of 1.0: NPV: $2.25 million, Pr = 1.0 You have contacted the expert and received a letter statin" rel="nofollow">ing his track record which you have checked out usin" rel="nofollow">ing several resources. Here is his stated track record: True State of the Market Expert Prediction Favorable Unfavorable Predicts “Favorable” .9 .3 Predicts “Unfavorable” .1 .7 You realize that this situation is a bit complicated sin" rel="nofollow">ince it requires the expert to analyze and predict the state of two different markets: the real estate market and the retail hat market. You thin" rel="nofollow">ink through the issues of probabilities and how to calculate the join" rel="nofollow">int probabilities of both markets goin" rel="nofollow">ing up, both goin" rel="nofollow">ing down, or one up and the other down. Based on your origin" rel="nofollow">inal estimates of success, here are your calculations of the sin" rel="nofollow">ingle probabilities and join" rel="nofollow">int probabilities of the markets. Probabilities Favorable Unfavorable A: Real Estate 0.50 0.50 B: Just Hats 0.75 0.25 Join" rel="nofollow">int Probabilities A Fav, B Fav (A+, B+) 0.375 A Unf, B Unf (A-, B-) 0.125 A Fav, B Unf (A+, B-) 0.125 A Unf, B Fav (A-, B+) 0.375 Fin" rel="nofollow">inally, after a great deal of analysis and calculation, you have determin" rel="nofollow">ined the Posterior probabilities of Favorable and Unfavorable Markets for the Real Estate busin" rel="nofollow">iness and the boutique hat busin" rel="nofollow">iness. Real Estate Just Hats F U F U 0.45 says "F/F" 0.75 0.25 0.90 0.10 0.15 says "F/U" 0.75 0.25 0.30 0.70 0.30 says "U/F" 0.125 0.875 0.90 0.10 0.10 says "U/U" 0.125 0.875 0.30 0.70 For example, this table says that there is 45% chance that the expert will predict Favorable for both markets (F/F), and when he makes this prediction, there is a 75% chance that the Real Estate market will be favorable and 25% chance that it won’t, and also a 90% chance that the Hat market will be Favorable and 10% chance it won’t. You have developed a Decision Tree showin" rel="nofollow">ing the origin" rel="nofollow">inal collapsed solution and also showin" rel="nofollow">ing an expanded Decision Tree for evaluatin" rel="nofollow">ing the value of the expert’s in" rel="nofollow">information. You need to enter the probabilities in" rel="nofollow">into this tree to see if the expert’s in" rel="nofollow">information will in" rel="nofollow">increase the overall expected value of your decision. Download the Excel file with the in" rel="nofollow">incomplete Decision Tree: Decision Tree for BUS520 SLP 4 Complete the in" rel="nofollow">information in" rel="nofollow">in the Decision Tree in" rel="nofollow">in the Excel file. Determin" rel="nofollow">ine the Expected NPV of the decision if you were to consult the Expert. Does use of the Expert in" rel="nofollow">increase the value of your analysis? If so, by how much? Write a report to your private in" rel="nofollow">investment company and explain" rel="nofollow">in your analysis and your recommendation. Provide clear rationale/ justification for your decision. Upload both your written report and Excel file with the Decision Tree analysis to the SLP 4 Dropbox.