MSTC Program

Final Examination
Managing Technology and Business Risks

Spring 2017

I agree that I will not use any materials other than a one page summary of
notes, and that I will not use the internet in any way to contact others or to
browse for information.

Name: _Jon Kaminski________________________________________

This examination contains 3 questions worth a total of 100 points. Note that
the point totals are indicated for each part of the question. Please allocate
your time appropriately.

Good luck!
 Problem 1 (35 points)

A professor you know has agreed to organize a conference in the field of simulation one year
from now. Within the next two weeks, the professor must decide how many rooms to reserve
with the hotel where the conference will be located. On the one hand, the professor does not
want to reserve too few rooms because any potential conference participant who cannot get a
hotel room will choose not to register for the conference since he/she will have no place to stay.
On the other hand, the professor does not want to reserve too many rooms because he must pay
a penalty of $500 for any unused room out of the conference revenue. Assume that the potential
number of conference participants has a normal distribution with mean 600 and standard
deviation 100. Each potential conference participant who obtains a hotel room and registers for
the conference pays a conference registration fee of $395.
The professor decides to use the following spreadsheet and @RISK model to help him
decide how many room he must reserve with the hotel. In it he considers five different room
quantities: 400, 500, 600, 700, 800.

a) (3 points): What Excel formula goes in cell B8?

b) (3 points): What Excel formula goes in cell B12?

c) (3 points): What Excel formula goes in cell C12?

d) (3 points): What Excel formula goes in cell D12?

e) (3 points): What Excel formula goes in cell E12?

After running @RISK for the five possible hotel room quantities simulations (Simulation 1 =
400 rooms, Simulation 2 = 500 rooms, Simulation 3 = 600 rooms, Simulation 4 = 700 rooms,
and Simulation 5 = 800 rooms), the professor obtains the following results in the table below.
Each simulation was run for 10,000 iterations.

f) (3 points): Which simulation yields the largest median (50th percentile) revenue?

g) (3 points): Which simulation yields the largest average (mean) revenue?

h) (3 points): Which simulation has the most risk as measured by spread or dispersion in the
data? Please state clearly what statistic you used to answer this question.
i) (3 points): Are there any simulations in which there is at least than a 1 in 20 (i.e., 5%) chance
of getting a negative revenue? Briefly explain in one sentence.

j) (4 points): For each simulation what is the probability of exceeding $175,000 in revenue
(approximate these numbers as closely as possible from the data given in the above table).
Please put your answer in the following table:
Simulation 1 Simulation 2 Simulation 3 Simulation 4 Simulation 5

k) (4 points): In one sentence, please state how many hotel rooms you think that the professor
should reserve in advance and explain why.
 Problem 2 (40 points)

POCO is a large, well-diversified company with a broad mix of oil, gas and petrochemical
products and with interests in biofuels, wind, solar power and hydrogen. The company has a
history of taking new products and new processes for existing products from the drawing board
or laboratory stage to the commercial process stage. Joost Steenbeeke, the director of
operations at one of POCOs divisions, was interested in increasing POCOs process
development effectiveness. He studied a number of the companys case histories of successful
process and product development as well as some failures. He noted that some of the processes
had been scaled up directly from laboratory to commercial-scale facilities and some involved
the intermediate step of building and operating a pilot plant.

Joost realized that the decision of whether or not to build a pilot plant is greatly dependent on
the value of the information that the pilot plant is expected to provide because in nearly all
cases the only valuable product of a pilot plant is information (whether direct or indirect).
Direct information may relate to technical factors such as chemical reaction rates, heat and
mass transfer rates, yields, operating conditions, possible corrosion problems, power
requirements, and chemical processing-stage efficiencies. In some cases the actual products of
a pilot plant may be used as a test product or as a raw material in the next processing stage, and
in this case the objective is still to obtain informationindirect information on factors such as
quality and suitability.

Joost decided that the focus on information and the inherent uncertainty in the process made it
suitable for modeling using decision trees. As a result he chose to analyze the decision for a
pilot plant that was shortly going to be made by his division. He wanted to see what insights
he could generate by using this framework.

Joost decided that the basic decision could be simplified into three choices: build a pilot plant,
build the full-scale plant with no pilot plant, or abandon the project. For the purposes of the
analysis, if the full-scale plant were built with no pilot plant, the simplification was made that
the outcome would either be Good performance or Bad performance. In reality there were
an infinite number of possible outcomes from the decision to build the full-scale plant, but
these two outcomes were judged to be enough to represent the uncertainty in the initial analysis.

The assessment of the uncertain probabilities was carried out by a team of engineers and
marketing people who were able to make the overall assessment of the unconditional
probability of good performance of the full-scale plant to be .9. In assessing the probability of
the success of the pilot plant, the team realized that the information that would be obtained
from the pilot plant was far from perfect. For example, the team recognized that favorable
results from the pilot plant could still lead to poor performance in a full-scale plant. And, even
if the pilot plant did not perform well, the full-scale plant might still work, since some of the
lessons learned might be applied to improve the design of the full-scale plant. Further, it was
easier to assess the probability that the pilot plant would have favorable results conditional on
knowing whether or not the full-scale plant would have good performance than vice versa.

The team reasoned as follows. If the full-scale plant would have good performance, then they
estimated that the probability that the pilot plant would have a favorable performance level
would be approximately .95, and otherwise the pilot plant would have a .05 chance of
unfavorable performance. On the other hand, if the full-scale plant would have poor
performance, then the probability that the pilot plant would have favorable performance would
be only about .15, with a probability of .85 of unfavorable performance.

These probability assessments were based on the assumption that the full-scale plant would be
constructed based on the current design specifications. However, if the pilot plant results were
unfavorable, the team recognized that the full-scale plant could be redesigned at some cost, and
possibly retested. If this were to occur, then they estimated that the probability of good
performance from the full-scale plant would be .8.

Joost realized that each path on a decision tree must lead to an eventual outcome with a
corresponding value. The monetary values of these outcomes were estimated by considering
the present values of all profits from the full-scale plant assuming technical and marketing
success, and also the present values of all profits from the full-scale plant assuming a technical
failure and, therefore, some marketing difficulties. These estimates were made using a pro
forma Excel spreadsheet with projected sales and cost estimates over a 10 year time horizon.
There were some additional costs to consider, however, including the cost of constructing and
operating the pilot plant, the present value of the delay in the profits that would result from the
time required for the pilot study, and the outcomes if the full-scale plant were redesigned. On
the positive side, the construction and operation of the pilot plant was expected to result in
some savings in the construction costs for the full-sized plant as a result of the experience that
would be gained. These monetary outcomes are summarized in Table 1.

Table 1. Estimates of Monetary Outcomes

Description Value (millions)
Net present value of all profits assuming technical and marketing success $220 million
(Good performance). Note that the investment cost of the plant is included in
the NPV calculation.
Net present value of all profits assuming technical failure and, hence, -$50 million
marketing difficulties (Bad performance)
Current estimate of pilot plant construction and operating cost $10 million
Present value of cost of delay to the NPV of the full scale plant caused by the $4 million
pilot study
Present value of benefits and savings in construction costs of full-scale plant $2.5 million
as a result of pilot plant experience
Present value of cost of redesigning plant if pilot plant operation is $3 million
unsuccessful
Net present value of profits if pilot plant fails and the full-scale plant is $164.5 million
redesigned and it achieves good performance
Net present value of profits if the redesigned plant is unsuccessful in technical -$53 million
or marketing aspect and it achieves bad performance
Note: Figures shown are in present value terms and include all cash flows (present and future)
a. (10 points) First, suppose Joost considers only the options of building the full-scale plant
without building the pilot plant, or abandoning the project. What is the expected value of
building the full-scale plant? Show the simple decision tree below.

b. (5 points) What would be the value of controlling (or eliminating) the risk associated with
the full-scale plant?
c. (10 points) What would be the value of perfect information regarding the risk of the full-
scale plant? Show the appropriate tree and your calculations below.

d. (15 points) Next, suppose Joost adds the alternative to build the pilot plant. What is the
best decision? Should the pilot plant be built, or should the full-scale plant be built with
no pilot plant? Show the part of the decision tree to estimate the present value of the
alternative of building the pilot plant on the following page and calculate its expected value.
Compare the results with the alternative of not building this pilot plant. Which alternative
would you recommend? Use the information below and on the next page to answer these
questions.

95.0% 85.5%
Favorable
0 0
90.0% Pilot Plant
Good
0 0
5.0% 4.5%
Unfavorable
0 0
Full-scale Plant
Bayesian Revision
0
15.0% 1.5%
Favorable
0 0
10.0% Pilot Plant
Bad
0 0
85.0% 8.5%
Unfavorable
0 0
 98.2759% 85.5%
Good
0 0
87.0% Full-scale Plant
Favorable
0 0
1.7241% 1.5%
Bad
0 0
Pilot Plant
Bayesian Revision
0
34.6154% 4.5%
Good
0 0
13.0% Full-scale Plant
Unfavorable
0 0
65.3846% 8.5%
Bad
0 0
 Problem 3 (25 points)

Eric Clark was in the throes of settling terms and deciding whether and how to do the OS-7
project, a major implementation of Oracle software in all seven international locations of a
large multinational company (the client). The client had told Clark that they would like
Appshop to perform all of the consulting for the OS-7 project. Clark and a team of
consultants spent two weeks working on the strategy, scope, and timeline for this rollout.
Based on that analysis, Appshop had proposed to spend 1000 hours of work per month from a
variety of professionals. This would result in a total cost to Appshop (for the time of
professionals, their support personnel and related apportioned operating costs) of $140/hour.

Clarks team had projected that they would bill the client and receive at the end of each
month $175,000 for 24 months. This would provide a contribution of $35,000 per month.
This amounted to a present value contribution of $790 thousand for the OS-7 project using
the Appshop discount rate of % per month (which compounds to 6.2% per year).
After significant discussions, Appshop was told that they would be awarded the work but not
for the $175,000 monthly payment. The client offered two alternatives: equal payments of
$155,000 per month over 24 months or $125,000 per month plus a $1.5 million bonus paid at
the end of month 24 if the work is completed ahead of schedule with commendable
performance, using standard measurements against stated benchmarks. Even though a
system might work satisfactorily, and be tuned to meet a specific benchmark, the multiple
benchmarks were much harder to meet simultaneously. Based on previous experience with
other implementations, and the complexity and uniqueness of this international project,
Clarks team gave a consensus probability of 0.7 of achieving the bonus.

Appshop would earn a positive contribution under the clients equal payments offer. With
the bonus payment schedule, though, it all depended on receiving that bonus. If Appshop
does not accept one of the two pricing options currently offered, then the officers of the client
company have said that they will generate a Request for Proposal (RFP) and distribute it to
the Big 4 Appshop competitors.

If the RFP were issued, Appshop would bid their normal rate of $175,000 per month. At that
bid, the consensus estimate from the team was a 55 percent chance of winning, inasmuch as
they typically priced projects just below the Big 4. The terms of the RFP set by the client
were to pay 80% of the revenue amount bid directly each month to the winning bidder plus a
gain share at the end of the 24th month to make up for the 20% of the bid revenue not paid
out. The client would base the gain share on the documented savings they would realize due
to the new Oracle applications. This was a common approach in the software consulting
industry used successfully on some Appshop contracts in the past. Appshop would receive a
share of the savings according to the following schedule:

Savings Appshop Share of Savings

< $4.0 million 0
$4 million up to $6 million 20 percent of excess above $4 million
$6 million up to $8 million $400,000 plus 40 percent of excess above $6 million
> $8 million $1.2 million plus 60 percent of excess above $8 million

Clarks team had used prior experience and judgmental assessment of the OS-7
implementation to forecast the savings to be realized by the client. The result of their
discussions was that savings would have a triangular distribution with a low of $3.2 million, a
high of $12.8 million and a most likely value of $5.6 million.

a. (5 points) What would be the return associated with the equal payments alternative?
Hint: Consider using the Excel function PV.

b. (5 points) What would be the expected return associated with the bonus payment
alternative? What would be the standard deviation associated with the bonus payment
alternative? Hint: Consider solving this using problem using @Risk so that you can
obtain the expected value and the standard deviation. Copy your calculations below
(show the formulas), along with the solution.

c. (5 points) Now, consider the return from the RFP alternative. Develop a simple
@Risk model to estimate this return, and copy the model below (show the formulas).
Hint: You may want to use a nested IF statement, such as
IF(a>100,1000,IF(a>50,500),100).

d. (5 points) Report the expected value associated with this RFP alternative. Also, what
is the probability that Appshop will experience a loss if they chose this strategy?
e. (5 points) Which of these alternatives would you recommend, and why?