Decision Support Tools for Investment, Production and Cost Analysis

DECISION SUPPORT TOOLS
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Question 1
a) Utility function tends to highlight the viewpoint of an individual investor towards value of
money and risk. The utility function is dynamic and tends to change with time. Also, it differs
from individual to individual. Besides, the magnitude of money also impacts the utility function.
Standard gamble is used often in the healthcare industry for assessment of utility values related
to a particular disease and death. With regards to gambling, considering the uncertain outcome,
hence it would be required for gamblers that atleast certainty equivalent should be ensured which
is the minimum risk free returns. Based on this, the utility values are computed (Flick, 2015).
b) 1) It is apparent that decision needs to be taken with regards to investment in share or bond
considering three states of nature i.e. good, fair and bad. The stock returns would change
according to the state while the bonds return would remain constant.
Returns in stock market in good state = 14% *10000 = $ 1,400
Returns in stock market in fair state = 8% *10000 = $ 800
Returns in stock market in poor state = 0% *10000 = $ 0
Returns for bonds in each of the three states = 9% of 10000 = $ 900
Hence, the relevant decision matrix is shown below.
2) An optimist would choose the investment which would provide maximum payoff
(MAXIMAX strategy) which is stocks considering the possibility of earning $ 1,400 as the
payoff or returns.
3) Minimum payoff for stocks = $ 0
Minimum payoff for bonds = $ 900
Hence, a pessimist as per MAXIMIN strategy would choose to invest in bonds.
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4) The regret matrix is shown below.
Maximum is in case of stocks and hence investment in stock would be recommended.
5) EMV (Stocks) = 0.4*1400 + 0.4*800 +0.2*0 = $ 880
EMV (bonds) = $900
Hence, as per the EMV criterion, bonds would be preferred.
6) The following formula may be used.
EVPI=∑
i=1
S
{max U (si , a)} p (si)−E ¿ ¿ ¿U/ a*)
EVPI = (0.4*1400 + 0.4*900 + 0.2*900) – 900 = $ 200
Question 2
a) The EMV or Expected Monetary Value of producing a new electric razor is highlighted
below.
EMV (Electric Razor) = 100000*0.5 + (-60000)*0.5 = $ 20,000
Since, EMV is positive, hence Jerry should produce the new type of electric razor.
b) The revision in the prior probability is shown below.
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Favourable study related probability revision is shown below.
Unfavourable study related probability revision is shown below.
c) The estimation of posterior probability is shown below.
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