Dwayne Whitten president of Whitten Industries is considerin

Dwayne Whitten, president of Whitten Industries, is considering whether to build a manufacturing plant in north Texas. His decision is summarized in the following table: Favorable Unfavorable Market $420,000 -$300,000 $100,000 $15,000 Alternatives Market Build large plant Build small plant Don\'t Build Market Probability SO 0.40 $0 0.60 a) The correct decision tree for Dwayne is shown in Figure 3 (all payoffs are in thousands). b) To maximize the return, Dwayne\'s decision should be to Build small plant. c) For Dwayne, the expected value of perfect information (EVPI)(enter your answer as a whole number).

Solution

EXPECTED VALUE OF PERFECT INFORMATION (EVPI) = EXPECTED VALUE GIVEN PERFECT INFORMATION (EV/PI) – EXPECTED MARKET VALUE (EMV)

EMV (BUILD SMALL PLANT) = 100000(0.40)+(-15000)(0.60) = 31000

EMV (BUILD LARGE PLANT) = 420000(0.40)+(-300000)(0.60) = -12000

EMV (DON’T BUILD) = 0(0.40)+0(0.60) = 0

The maximum of these expectations is to build small plant. Not knowing which direction the market will go (only knowing the probability of the directions), we expect to make the most money from building small plant.

Thus,

EMV = 31000

On the other hand, consider if we did know ahead of time which way the market would turn. Given the knowledge of the direction of the market we would (potentially) make a different investment vehicle decision.

Expectation for maximizing profit given the state of the market:

EV/PI = 420000(0.40) + 0(0.60) = 168000

That is, given each market direction, we choose the investment vehicle that maximizes the profit.

Hence,

EVPI = EV/PI – EMV = 168000 – 31000 = 137000

Conclusion:

Knowing the direction the market will go (i.e. having perfect information) is worth $137000.