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Answers to Additional Questions – Risk and Uncertainty

01
(a)
The expected size of the audience is:
(300 x 0.5 ) + (400 x 0.3) + (500 x 0.2) = 370 people

The expected value of contribution from non-ticket sales is:

($3 x 0.3) + ($5 x 0.5) + ($10 x 0.2) = $5.40

Ticket price = $25.00

Expected income ($25.00 + $5.40) x 370 $11,248

Less MS fee $10,000
Expected gain $1,248

The MS should be engaged for the concert.

(b)

Size of audience
300 400 500
Contribution from confectionery sales
$3 (1,600) 1,200 4,000
$5 (1,000) 2,000 5,000
$10 500 4,000 7,500

All values shown in the cells of the above table are in $

( c)

The probabilities can be combined to show the probability of each of the nine possible
outcomes occurring. These are shown in the following table:

Size of audience
300 400 500
Contribution from confectionery
sales
$3 15% 9% 6%
$5 25% 15% 10%
$10 10% 6% 4%

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By combining the values that have been summarized in these two tables it can be seen that there
is a 40% chance of the concert making a loss (and hence a 60% chance of it having a profit).
Furthermore it can be seen that the solution found in part (a) is and average value and that the
range of possible results is from a loss of $1,600 to a profit of $7,500. The probabilities can also
be used to demonstrate that the distribution of possible values is skewed, because the probability
of the profit being above the average (expected) value of $1,248 is 41%.

The theatre management can use this information to evaluate their decision more thoroughly.
Instead of relying on a single possible value these tables show the range of values that could
occur and the likelihood of each of them occurring. The information therefore allows the theatre
management to consider the risks associated with their decision.

d)

The maximum price should be paid for the information is the difference between the expected
value that would result from actions taken with the information compared to the expected value
calculated without the information (as already calculated above $1,248).

There are two aspects to the information: the size of the audience and the level of contribution
from confectionery sales.

The possible combinations/decisions and their probabilities and expected values are as follows:

Audience Confectionery Outcome Decision Probability Expected

Contribution Value
($) ($) ($)
300 10 500 Yes 0.1 50
300 5 (1,000) No
300 3 (1,600) No
400 10 4,000 Yes 0.06 240
400 5 2,000 Yes 0.15 300
400 3 1,200 Yes 0.09 108
500 10 7,500 Yes 0.04 300
500 5 5,000 Yes 0.1 500
500 3 4,000 Yes 0.06 240
Total 1,738

The value of the information and therefore the maximum price that should be paid for it is $
1,738 less $1,248 = $490.

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02.a

Year 1 Demand Years 2 & 3 Demand

Low

Medium

Low Low
Medium Medium
High
High
Medium
High
Investment B
Low
Low Medium
Investment A Medium High

High Low
Medium
High
No investment Medium
High

Low
Medium
Low
Medium Low
Medium
High High

Medium
High

* Student were not expected to show the probabilities or the values with the branches under this
question but in future do ensure that you show at least the probabilities with the branches. The
branches with no probability you can exclude. There will also be few students confused with particularly
in investment A how the high demand branch is created if you carefully read you will see although the
investment A is not giving the high level of operation the health clinic can always buy it from external
source.

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02.b

To identify the year 2 and 3 expected value we need the joint probabilities, this is because the year 2 & 3
costs depends on year 1 situation, but the year 1 expected calculation should be done separately (taking
only year 1 probabilities) since year 1 costs are not depended on year 2&3 costs(probabilities). There
are no. of ways you could have done this but the most convenient method to calculate is given below;

Investment in Facility B

Year 0 cost £ 800,000

Year 1 expected cost:

Low 30% x £300,000 = £ 90,000
Medium 50% x £350,000 = £175,000
High 20% x £400,000 = £345,000

Years 2 & 3 expected cost per

year :
Low 27% x £300,000 = £81,000
Medium 44% x £350,000 = £154,000
High 29% x £400,000 = £116,000
£351,000 x 2 years = £702,000

Total present value of cost £1,847,000

Investment in Facility A

Year 0 cost £500,000

Year 1 expected cost:

Low 30% x £250,000 = £75,000
Medium 50% x £350,000 = £175,000
High 20% x £500,000 = £100,000
£350,000
Year 2 & 3 expected cost per year
Low 27% x £250,000 = £67,500
Medium 44% x £350,000 = £154,000
High 29% x £500,000 = £145,000
£366,500 X 2 years = £733,000
Total present value of cost £1,583,000

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No investment

Year 1 expected cost:

Low 30% x £300,000 = £90,000

Medium 50% x £400,000 = £200,000
High 20% x £550,000 = £400,000

Year 2 & 3 expected cost per year

:
Low 27% x £300,000 = £81,000
Medium 44% x £400,000 = £176,000
High 29% x £550,000 = £159,500
£416,500 x 2 years = £833,000

Total present value of cost £1,233,000

Note- this is how the probabilities (joint) were calculated and summed.

W1: Calculation of probabilities for years 2 and 3

Year 1 Year 2 and 3 Probability

demand demand
Low Low 0.3 x 0.4 0.12
Medium Low 0.5 x 0.3 0.15
High Low 0.2 x 0.0 0.00 Total 0.27

Low Medium 0.3 x 0.6 0.18

Medium Medium 0.5 x 0.4 0.2
High Medium 0.2 x 0.3 0.06 Total 0.44

Low High 0.3 x 0.0 0.00

Medium High 0.5 x 0.3 0.15
High High 0.2 x 0.7 0.14 Total 0.29

On purely financial grounds, using the expected cost basis, no further investment should be
undertaken

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02.c

By not undertaking further investment to increase the ability of the health clinic to service the
increasing levels of demand the manager is becoming reliant on the use of other facilities that of
the services provided, the reliability of the external service provision, and the vulnerability of the
health clinic to increasing fees being charged by the external facility providers.

Furthermore the employees of the health clinic may become less motivated as they see that there
is a tendency to utilize external facilities rather than invest within the business. This may
illustrate a tendency towards short term cost control to the detriment of the operation of the
health clinic in the longer term.

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03.01.

£
Selling price expected value = (£20 x 25%) + (£25 x 40%) + (£30 x 35%) = 25.50
Variable cost expected value = (£8 x 20%) + (£10 x 50%) + (£12 x 30%) = 10.20
Expected unit contribution 15.30

1,000 unit x £15.30 = £ 15,300

The correct answer is D

03.02.

The total contribution must exceed £13,500, so to achieve this from a volume of 1,000 units, the unit
contribution must exceed £13.50. These following combinations of selling price and variable cost and
their respective combined probabilities meet this target.

Selling Price Variable cost Probability

£ £
25 8 0.4 x 0.2 =0.08
25 10 0.4 x 0.5 =0.20
30 8
30 10 0.35 x 1.0 = 0.35
30 12

Combined probability total 0.63

The correct answer is C

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04.

You need to identify that there are three options available and that three situations possible. And
under each situation if the best is not selected then the regret, which you can now quantify, once
that is over get a new column done which shows the maximum regret, and this you want to
minimize (minimax regret).

Regret table
Sale / Demand
Maximum Regret
Make 10 11 12
10 0 50 100 100
11 20 0 50 50
12 40 20 0 40

The answer is to make 12.

05.

Weekly contribution of $20,000 if sales demand = 1,000 units equals a contribution of $20
per unit.

The following combinations of selling price and variable cost per unit yield a contribution of
more than $20 per unit:

Selling Price Variable Cost Probability

$50 $20 0.45 x 0.55 = 0.2475
$60 $30 0.25 x 0.25 = 0.0625
$60 $20 0.25 x 0.55 = 0.1375

Answer = 44.75%