CHAPTER 9

RISK AND UNCERTAINTY

BAIBF09013 ADVANCED PERFORMANCE MANAGEMENT

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QUESTIONS

1. An organisation is considering launching a new product. It will do so if the expected

value of the total revenue is in excess of $1,000. It is decided to set the selling price at
$10After some investigation a number of probabilities for different levels of sales revenue
are predicted. These are shown in the following table.
Units Sold Probability
80 0.15
100 0.5
120 0.35

What is the expected sales revenue at a selling price of $10 per unit?

2. A company buys in sub-assemblies in order to manufacture a product. It is reviewing its

policy of putting each sub-assembly through a detailed inspection process on delivery,
and is considering not inspecting at all. Experience has shown that the quality of the
sub-assembly is of acceptable standard 90 per cent of the time. It costs $10 to inspect a sub-
assembly and another $10 to put right any defect found at that stage. If the sub-assembly
is not inspected and is then found to be faulty at the finished goods stage the cost of
rework is $40.

Advise the company whether or not they should change their policy.

3. An individual is considering backing the production of a new musical in the West End. It
would cost $100,000 to stage for the first month. If it is well received by the critics, it will
be kept open at the end of the first month for a further 6 months, during which time further
net income of $350,000 would be earned. If the critics dislike it, it will close at the end of
the first month. There is a 50:50 chance of a favourable review.

Should the individual invest in the musical?

4. A company is considering whether to make product X or product Y. They cannot make

both products. The estimated sales demand for each product is uncertain and the
following probability distribution of the NPVs for each product has been identified.

Product X

NPV Probability
3,000 0.1
3,500 0.2
4,000 0.4
4,500 0.2
5,000 0.1

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 Product Y

NPV Probability
2,000 0.05
3,000 0.1
4,000 0.4
5,000 0.25
6,000 0.2

Calculate what product to produce based on

a. Expected Values
b. Standard Deviations
c. Calculate the Co-efficient of variation of these two products

5. A company who are unsure about both selling price and variable cost. They believe that
selling price may be either $40 or $50 depending on differing market conditions, and
that variable production cost will be either $20 or $30 depending on wage negotiations
currently taking place.

Calculate the possible contributions per unit.

6. Geoffrey Ramsbottom runs a kitchen that provides food for various canteens
throughout a large organization. A particular salad is sold to the canteen for $10 and
costs $8 to prepare. Therefore, the contribution per salad is $2.

Based upon past demands, it is expected that, during the 250-day working year, the
canteens will require the following daily quantities.
On 25 days of the year - 40 salads
On 50 days of the year - 50 salads
On 100 days of the year - 60 salads
On 75 days - 70 salads

The kitchen must prepare the salad in batches of 10 meals and it has to decide how
many it will supply for each day of the forthcoming year.

a. Construct the pay-off table

b. Identify the decisions to be made based on the Maximax, Maximin and Minimax regret
criteria
c. A new ordering system is being considered, whereby customers must order their salad
online the day before. With this new system Mr Ramsbottom will know for certain the
daily demand 24 hours in advance. He can adjust production levels on a daily basis.
How much is this new system worth to Mr Ramsbottom?

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7. A company is assessing the desirability of producing a souvenir to celebrate a royal
jubilee. The marketing life of the souvenir will be 6 months only. Uncertainty surrounds
the likely sales volume and contribution, as well as the fixed costs of the venture.
Estimated outcomes and probabilities are

Units Contribution Fixed

Probability Probability Probability
sold per unit Cost
100,000 0.3 400,000 0.2
7 0.5
80,000 0.6 450,000 0.5
5 0.5
60,000 0.1 500,000 0.3

Find the expected value.

8. An oil company has recently acquired rights in a certain area to conduct surveys and
geological test drillings that may lead to extracting oil where it is found in commercially
exploitable quantities.

The area is already considered to have good potential for finding oil in commercial
quantities. At the outset the company has the choice to conduct further geological tests or
to carry out a drilling programme immediately. On the known conditions, the
company estimates that there is a 70% chance of further tests indicating that a significant
amount of oil is present.

Whether the tests show the possibility of oil or not, or even if no tests are undertaken at
all, the company could still pursue its drilling programme or alternatively consider
selling its rights to drill in the area. Thereafter, however, if it carries out the drilling
programme, the likelihood of final success or failure in the search for oil is considered
dependent on the foregoing stages.

(i) If the tests indicated that oil was present, the expectation of success in drilling is
given as 80%
(ii) If the tests indicated that there was insufficient oil present, then the expectation of
success in drilling is given as 20%
(iii) If no tests have been carried out at all, the expectation of finding commercially
viable quantities of oil is given as 55%.
Costs and revenues have been estimated for all possible outcomes and the net present
value of each is given below.

Outcome NPV ($ millions)

Geological testing (10)
Drilling cost (50)
Success in finding oil 150

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 Sale of exploitation rights
Tests indicate oil is present 65
Tests indicate ‘no oil’ 15
Without geological tests 40

a. Prepare a decision tree diagram to represent the above information

b. For the management of the company, calculate its best course of action
c. Explain the value of decision trees in providing management with guidance
for decision making.

9. A company is choosing which of three new products to make (A, B or C) and has
calculated likely pay-offs under three possible scenarios (I, II or III), giving the following
pay-off table.
A B C
I 20 80 10
II 40 70 100
III 50 (10) 40

(i) What option will be chosen using

a. Maximax
b. Maximin
c. Minimax Regret
(ii) Compute the value of information assuming probabilities of 20%, 50% and 30%
for scenario i, ii and iii.

10. Identify the correct description of imperfect information

a. Costs more to collect than its value to the business
b. Is available only after preliminary decisions on a business venture have been taken
c. Does not take into account all factors affecting a business
d. May contain inaccurate predictions

11. A company is considering investing in one of the following projects.

Project EV SD
A 850 500
B 1,200 480
C 150 200
D 660 640

It wishes to select the project with the lowest risk factor. Identify which project should it
select
a. Project A
b. Project B
c. Project C
d. Project D

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12. The RS Group owns a large store in Ludborough. The store is old fashioned and profits
are declining. Management is considering what to do. There appear to be three
possibilities.
(1) Shut down and sell the site for $15m
(2) Continue as before with profits declining
(3) Upgrade the store

The Group has had problems in the past and experience suggests that when stores are
upgraded, 60% achieve good results and 40% poor results.

Because of the doubts, management is considering whether to contact a leading market

research company to carry out consumer research in Ludborough for $1m. It has been
fortunate in obtaining details of the track record of the research company as follows.

Actual Outcome
Good Poor
Positive 0.85* 0.1
Negative 0.15 0.9

* This means that when the actual results were good the research had predicted this 85%
of the time.
If the research indicates a positive attitude, management will consider deluxe upgrading
which will generate more profit but will cost $12m, as compared with standard
upgrading costing $6m.
If the research indicates a negative attitude, then management will consider standard
upgrading compared with shutting down and selling the site.
The time scale for the analysis is 10 years and the following estimates of returns have
been made.
With Deluxe Upgrading Good results $40 million PV
With Deluxe Upgrading Bad results $20 million PV
With standard upgrading Good results $25 million PV
With standard upgrading Bad results $10 million PV

If operations continue as before returns over the next 10 years will be $13.03m in present
value terms.

Required
a. Prepare a decision tree to represent the above information
b. Calculate what decisions should be taken
c. Explain the basis of your analysis

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13. For the past 20 years a charity organisation has held an annual dinner and dance with
the primary intention of raising funds. This year there is concern that an economic
recession may adversely affect both the number of people attending the function and the
advertising space that will be sold in the program published for the occasion. Based on
past experience and current prices and quotations, it is expected that the following costs
and revenues will apply for the function.

Hire of premises $700

Band and entertainers $2,800
Dinner and Dance Raffle prizes $800
Photographer $200
Food at $12 per person (with a guarantee of 400 persons
minimum)
Program A fixed cost of $2,000 plus $5 per page
Price of tickets $20 per person
Dinner and dance Average revenue from raffle $5 per person
Photographs $1 per person
Program Average revenue from advertising $70 per page

A sub-committee, formed to examine more closely the likely outcome of the function,
discovered the following from previous records and accounts.

Number of Number of
tickets sold past
occasions
250-349 4
350-449 6
450-549 8
550-649 2

Number of Number of
programs past
sold occasions
24 4
32 8
40 6
48 2

Required
Calculate the expected value of the profit to be earned from the dinner and dance this
year.

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14. Amador Ltd is considering investing $120,000 in equipment that has a life of 15 years. Its
final scrap value is $25,000. The equipment will be used to produce 15,000 deluxe pairs of
rugby boots per annum, generating a contribution of $2.75 per pair. Specific fixed costs
are estimated at $18,000 per annum. The firm has a 15% cost of capital.

Calculate the
a. NPV of the project
b. Calculate the sensitivity of your NPV to the
(i) Initial investment
(ii) Contribution
(iii) Fixed costs
c. Identify the minimum annual sales required to ensure that the project at least breaks
even.

15. Cement Co is a listed company specialising in the manufacture of cement, a product used
in the building industry. The company has been a major player in the construction sector
of European country, Q, since its formation in 1997. It is passionate about customer care
and proud of its active approach to safety and sustainability (recognising the need to
minimise any adverse environmental impact of its operations).

The company operates in a very traditional industry but profits can be volatile. Q’s
economy has been in recession for the last three years and this has had a direct impact on
Cement Co’s profitability. Shareholders are concerned about this fall in profit and have
expressed their desire for a secure return. Competitors, keen to find ways of increasing
profit and market share, in these difficult economic circumstances, have started to increase
the level of investment in research and development, ensuring their products anticipate
and meet the needs of its customers.

When Q entered recession, many workers left the country in search of more lucrative and
secure work. This has had a significant impact on Cement Co which is now facing labour
shortages and increased labour costs. At the same time, suppliers have also increased their
prices putting further pressure on Cement Co’s margins.

The company has found that when weather conditions are good, the demand for cement
increases since more building work is able to take place. Last year, the weather was so
good, and the demand for cement was so great, that Cement Co was unable to meet
demand. Cement Co is now trying to work out the level of cement production for the
coming year in order to maximise profits. The company doesn’t want to miss out on the
opportunity to earn large profits by running out of cement again.

However, it doesn’t want to be left with large quantities of the product unsold at the end
of the year, since it deteriorates quickly and then has to be disposed of. The company has
received the following estimates about the probable weather conditions and
corresponding demand levels for the coming year.

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 Weather Probability Demand
Good 25% 350,000 bags
Average 45% 280,000 bags
Poor 30% 200,000 bags

Each bag of cement sells for $9 and costs $4 to make. If cement is unsold at the end of the
year, it has to be disposed of at a cost of $0.50 per bag.

Cement Co has decided to produce at one of the three levels of production to match
forecast demand. It now has to decide which level of cement production to select.

As an incentive to increase profitability a new bonus scheme has just been introduced for
a select group of Cement Co’s directors. A bonus will be received by each of these directors
if annual profit exceeds a challenging target.

Required
a. Identify the risks facing Cement Co and assess the impact of different risk appetites of
managers and shareholders on their response to these risks.
b. Evaluate the proposed levels of cement production using methods for decision
making under risk and uncertainty and assess the suitability of the different methods
used.

16. A bank has estimated that the expected value of its portfolio in 10 days’ time will be $30
million, with a standard deviation of $3.29 million.

Required
Using a 99% confidence level, identify the value at risk.

17. 40% of the output of a factory is produced in workshop A and 60% in workshop B.
Fourteen out of every 1,000 components from A are defective and six out of every 1,000
components from B are defective.

After the outputs from A and B have been thoroughly mixed, a component drawn at
random is found to be defective. What is the probability that it came from workshop B?

18. 30% of the new cars of a particular model are supplied from a factory X, the other 70%
from factory Y. 10% of factory X’s production has a major fault, 12% of factory Y’s
production has such a fault.
A purchaser’s new car has a major fault.
What is the probability that it was made at factory Y?

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19. A manufacturer is concerned about the potential loss of a major client. The manufacturer
has already prepared the following budget for the year:
Revenue $480,000
Cost of sales 200,000
Other operating costs $80,000
Gross profit $200,000

The manufacturer wants to stress test the budget for the loss of the major customer who
makes up 25% of its total sales. This customer provides a margin of 15% on sales.

What would be the revised budgeted profit if the customer’s sales were lost?
a. $182,000
b. $80,000
c. $110,000
d. $150,000

20. Which THREE off the following are disadvantages of scenario planning?
a. Bounded rationality
b. Reduce communication within the organization
c. High cost
d. Risk of self-fulfilling prophecy
e. Waste management time
f. Discourages creative thinking

21. A company can make either of two new products, X and Y, but not both. The profitability
of each product depends on the state of the market, as follows.

Market Profit from product Probability of

state X ($) Y ($) market state
Good 20,000 17,000 20%
Fair 15,000 16,000 50%
Poor 6,000 7,000 30%

Calculate the expected value of perfect information as to the state of the market.
a. $0
b. $600
c. $800
d. $1,000

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22. The Venus Department Store operates a customer loan facility. If one of its new customers
requests a loan then Venus either refuses it, gives a high loan limit, or gives a low loan
limit. From a number of years past experience the probability that a new customer makes
a full repayment of a loan is known to be 0.95, whilst the probability of non-repayment is
0.05 (these probabilities being independent of the size of loan limit). The average profit in
$, per customer made by Venus is given by the following table.
High Low
Full-repayment 50 20
Non-repayment -200 -30

Required:
a. In the past the company has used a selection criterion that is totally arbitrary (i.e. it is
not influenced by the customer's ability to repay).
b. Venus can apply to an agency to evaluate the credit-rating of a customer. This agency
would provide a rating for the customer as either a good risk or as a bad risk, this
credit-rating being independent of the size of the loan being considered. Analysis of
the last 1,000 customer ratings by this agency revealed the following information.

Credit Type of customer Total

rating Full-repayment Non-repayment
Good Risk 790 10 800
Bad Risk 160 40 200
Total 950 50 1000

Determine the value of this credit rating to Venus.

c. The Venus management believe that this first agency is not very good at selecting full-
payers and non-payers. It considers contacting a second agency which guarantees
perfect information concerning the credit rating of the customers.
(i) Explain the meaning of the term 'perfect information' in the context of this
question.
(ii) Calculate the value of this perfect information.

23. Three investors are considering the same investments. The net return from the
investments depend on the state of the economy and are illustrated as follows.

State of Returns from investment Probability of

the economic
economy A B C state
Good 6,000 14,000 3,000 10%
Fair 5,000 3,000 5,000 40%
Poor 4,000 500 8,000 50%

Details on the attitudes to risk of the three investors is as follows:

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  Micah is risk neutral
 Zhang is a risk seeker
 Jill is risk averse and typically follows a minimax regret strategy with her
investments.

Calculate which investment would be best suited to each investor's risk attitude.

24. An importer has produced the following budget for next month
Sales 64
Material costs (28)
Labour costs (12)
Overhead costs (18)
Gross profit 6

The importer wants to stress test the budget for a potential change in currency rates on
the products that it imports. A currency change would increase material costs by 10%,
only half of which could be passed on to the importers powerful customers.

The revised gross profit for the month would be $_______ (round to the nearest $)

25. A manager is considering a make vs buy decision based on the following estimates.
If made in-house If buy in and re-badge
Variable production costs 10 2
External purchase costs - 6
Ultimate selling price 15 14

Identify the sensitivity of the decision to the external purchase price.

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