Set up a decision tree to find the bid that gives Genesis the highest chances of

Question

Set up a decision tree to find the bid that gives Genesis the highest chances of winning. If It Ain't Broke Orthopedics is leasing a facility in Los Angeles for $20,000 per month The partners are deciding on whether to buy a property and relocate the clinic or to continue leasing the current facility for another year and then relocate the clinic They recently saw an advertisement for a new medical complex in Glendale at a price of $2,800,000. The current interest rate for a 20-year loan is 7 percent per annum. They believe there is a 40 percent chance that this interest rate will fall to 5 percent per annum in a year's time. They also believe that another facility they are interested in will still be available in a year at a discounted price of $2,500,000. The partners have to decide whether to buy the new facility now or in a year. Interest payments will be made on the loan at the end of each year. Develop a decision tree that will aid the owners in their leasing or purchasing decision. Fold back the tree and find the expected value. Victoria is currently a project manager for EPIC, an established integrated software that services midsize to large health care organizations Currently, her annual base salary is $1,50,000 per year She also is eligible for a bonus at the end of the year, equaling 5 percent of all revenues if the company makes above $1,600,000 and 10 percent of all revenues if above $3 million. She is debating whether to leave this lucrative job to set up her own company. Although she has established client relationships, she believes only 65 percent of all existing clients will follow her in this new endeavor. Based on the previous year's performance, she believes there is a 25 percent chance the contracts would be worth $1,200,000, a 45 percent chance the contracts would be worth $2 million, and a 30 percent chance the contracts will be worth $3 million. She estimates that the total cost of operating her own company would be $700,000. Develop a decision tree to help Victoria decide whether she should set up her own company. Fold back the tree and find the expected value.

Explanation / Answer

Q6 (a) In this problem we will address through financial mathematics in terms of Present Values

The firm needs to decide whether or the possible decisions. Let us define the scenarios

d1 : Firm continues to pay the lease rent @ $ 20000 per month

d2: Buys the property immediately in Glendale which is at $ 2800,000

d3: Buys the property later after at discounted price at $ 2500000

For each of the above decisions we will calculate the Present Value of Payments and arrive at the decision tree.

Let us consider d1

Let us assume that the clinic will run for the next 20 years and we will pay the lease @ $20000 per month for 20 years. We will caluclate the Present Value at i = 0.07 and i=0.05 the rate of interests.

Let us denote the Present Value (PV)

Now PV = 20000 x 12 x i/i (p) x an

Here n = 20 years and p = 12

an = (1-vn)/i and v =1 /(1+i)

Therefore for i =0.07 and i (p) = p( (1+i) 1/p -1)

We have PV = 20000x 12 x 0.07x 10.594/(0.06785)

PV = $ 2623127

Now there is possibility of 40% that interest after one year will become 5% in this i=0.05

And for the first year the rate of interest will be 7%

PV = 240000 x v@ 7% x {i/i(12) @ 5% x a19 @ 5%}

PV = 2772324

Now the Expected PV for the lease will be = $ 2623127 x 0.6 + $ 2772324 x0.4 = $ 2682806

Now for d2

PV = $ 2800,000 since this immediate

Now for d3

Since this purchased at $ 2500000 a year later we will calculate the PVs at i =0.07 since interest

PV = $ 2500000 v@7% = 2500000 x 0.93458 = $ 2336450

Now the decision matrix is as follows

d1 = $ 2682806

d2 = $ 2800000

d3 = $ 2336450

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Q 6 (b) The expected value will be if all the decisions are equally likey we have as follows

Expected Value = $2682806 x 1/3 + $ 2800000x 1/3 + $ 2336450 x 1/3 = $ 2606419

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Q 7 ( a)

Let d1 = Continues in the job

     d2=Sets up his own business

We will construct the table of profit in this (net earnings)

In this case profit = Base Salary + Bonus

Let p = probablity of the Company revenue's

We construct the table

Therefore the expected profit = 150,000x0.25 +250,000x0.45 + 0.3x 450000

                                          = $ 285000

Now for d2

We construct the table as follows when he sets his own business

Expected profit =0.25 x 80000 + 0.45 x 600,000 + 0.30 x 1250,000

= $ 665,000

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7 (b)

Expected value = 0.5 x 285000 + 0.5 x 665000

= $ 475000

p=probabilty Revenues in $ Bonus Profit = Base Salary + Bonus 0.25 1,200,000 0 150,000 0.45 2,000,000 100,000 250,000 0.30 3,000,000 300,000 450,000

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