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- QUESTION
Risk: Exponential Smoothing Forecasting and Value of Information
Scenario: Using the same situation from SLP 3, recall that you are deciding between three investments. You have heard of an Expert who has a “track record†of high confidence in correctly identifying when market conditions are favorable or not. You are now considering whether to consult this “expert†and if it would be worth paying his fee to get his prediction. So you are going to do further analysis to determine the value of this information that the expert might provide.
In order to simply the analysis a bit, you have decided to look at two possible outcomes for each alternative instead of three. You are interested in whether the market will be Favorable or Unfavorable, so you have collapsed the Medium and Low outcomes. Here are the three alternatives with the adjusted NPV outcome and probabilities.
Option A: Real estate development. This is a risky opportunity with the possibility of a high payoff, but also with no payoff at all. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the Net Present Value of the cash flow and probabilities.
High/Favorable NPV: $5 million, Pr = 0.5
Unfavorable NPV: $1.2 million, Pr = 0.5Option B: Retail franchise for Just Hats, a boutique type store selling fashion hats for men and women. This also is a risky opportunity but less so than option A. It has the potential for less risk of failure, but also a lower payoff. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the Net Present Value of the cash flow and probabilities.
High/Favorable NPV: $3.4 million, Pr = 0.75
Unfavorable NPV: $2 million, Pr = 0.25Note that this option requires less investment, so there is $0.2 million available, which will be invested in the same bonds as Option C. The NPV of this investment in this option (B) is $0.4 million. This has been added to NPV for the Favorable and Unfavorable outcomes of the boutique.
Option C: High Yield Municipal Bonds. This option has low risk and is assumed to be a Certainty. So there is only one outcome with probability of 1.0
NPV: $1.5 million, Pr = 1.0
You have contacted the Expert and received a letter stating his track record which you have checked out by several resources. Here is his stated track record:
True State of the Market
Expert Prediction Favorable Unfavorable
Predicts “Favorable†.9 .3
Predicts “Unfavorable†.1 .7You realize that this situation is a bit complicated since it requires the expert to analyze and predict the state of two different markets: the real estate market and the retail hat market. You think through the issues of probabilities and how to calculate the joint probabilities of both markets going up, both going down, or one up and the other down. Base on your original estimates of success, here are your calculations of the single probabilities and joint probabilities of the markets.
Probabilities Favorable Unfavorable
A: Real Estate 0.50 0.50
B: Just Hats 0.75 0.25Joint Probabilities
A Fav, B Fav (A+, B+) 0.375
A Unf, B Unf (A-, B-) 0.125
A Fav, B Unf (A+, B-) 0.125
A Unf, B Fav (A-, B+) 0.375Finally, after a great deal of analysis and calculations, you have determined the Posterior probabilities of Favorable and Unfavorable Markets for the Real Estate business and the boutique hat business.
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| Subject | Business | Pages | 5 | Style | APA |
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Answer
Exponential Smoothing Forecasting and Value of Information
An investor is faced with a dilemma of investing in a real estate development, a retail franchise or a municipal bond. The investor could invest in a real estate development as option A, which has a probability of a high pay off, or no pay off. Further, the high pay off could have an NPV of $5 million with a probability of 0.5 while the low pay off could have an NPV of $ 1.2 million with a probability of 0.5. The investor also has option B, which has a lower potential of failure and payoff. Specifically the investment could end up with an NPV of $3.4 million with a probability of 0.75 or a NPV of $2 million with a probability of 0.25. Ultimately, the investor could invest in option C, High Yield Municipal Bonds, which has a 100% chance of getting an NPV of $1.5 million. Critical to the discussion is the fact that the investor could consult an expert’s opinion on the subject, or make an investment decision without consulting the expert. Consequently, this paper uses Bayesian analysis to recommend that the company should consult an expert before making an investment decision.
After analyzing the possible investment decisions using decision trees, it becomes clear that the investor has an option to consult or not consult an expert. Assuming the investor does not consult an expert, investing in a real estate development will result in a net present value of $3.1 million. However, consulting an expert would result in a net present value of $4.05 million if the market is favorable and $1.675 million if the market is unfavorable. Analogously, the investor will have an NPV of $3.05 million if he invests in a real estate franchise without consulting an expert. On the contrary, the investor will have an NPV of $ 3.26 million from the retail franchise if the market is favorable and $2.42 million if the market is unfavorable. Ultimately, the investor will have an NPV of $ 1.5 million if he invests in government bonds. Critical to the discussion is the fact the NPV from government bonds is constant regardless of whether or not the investor consults an expert. Above all, consulting an expert would result in a net present value of $3.65 million for all the investment vehicles.
From the analysis above it is evident that investing in a real estate development results in the highest NPV if the market is favorable while investing in government bonds results in the lowest NPV. Similarly, it clear that investing the retail franchise results in the highest NPV if the market is unfavorable while investing in government bonds results in the lowest NPV. It follows that the best investment decision should be made depending on the risk appetite of the investor. However, the main decision was to determine whether consulting an expert would increase the value of the analysis or not. Consequently, it should be noted that consulting an expert would result in a possible net present value of $3.65 million while failure to consult an expert would result in a possible net present value of $3.1 million. This implies that consulting an expert increases the value of the analysis by $0.55 million. I would recommend that the company consults an expert before making an appropriate investment decision.
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