Question

Best Buy USA must to decide whether to build a new distribution center in Paramus, New Jersey, to serve its stores in the Northeast region of the United States. The options it has can be simply described as building a small, medium-size, or large facility. The costs and expected returns have been thoroughly estimated but one big question remains: what will be the general level of the demand for the entire range of products that Best Buy USA distributes? Three possible levels of demand in this Northeast region are being considered, depending on the moves by its competitors (there is talk of a competitor going bankrupt, but also some rumors that a new chain is planning to enter the NE market) and the speed of recovery of the economy: a) low (combination of slow economic recovery, additional investments by competitors and low-to-average acceptance of the company’s new products), b) average, and c) high (combination of speedy economic recovery, one or more competitor exiting the market, and high acceptance of the company’s new products). Expected returns A small facility is expected to earn an after-tax net present-value of just $45 M if demand is low. If demand is average, the small facility is expected to earn $90 M; it can be increased to medium size to earn a net present value of $85 M. If demand is high, the small facility is expected to earn $105 M and can be expanded to medium size to earn $100 M or to large size to earn $125 M. A medium-size facility is expected to lose an estimated $30 M if demand is low and earn $140 M if demand is average. If demand is high, the medium-size facility is expected to earn a net present value of $175 M: it can be expanded to a large size for a net payoff of $165 M. If a large facility is built and demand is high, earnings are expected to be $250 M. If demand is average for the large facility, the present value is expected to be $100 M. If demand is low, the facility is expected to lose $100 M. PART I 1. Draw a decision tree for this situation 2. Which alternative would Best Buy USA choose if its management were to apply each of the following decision-making criteria? a) maximax; b) maximin; c) minimax regret 3. Assuming that the best market forecasters assign the probabilities below to the three possible levels of demand, determine the expected value of each alternative action. P(Low demand) = 20% P(Average demand) = 40% P(High demand) = 40% 4. The management of Best Buy USA can pay $10M to a fortuneteller with a magic crystal ball. This fortuneteller can look into the future now and predict, error-free, the future state of demand. What is the expected value of this information? Is it worth the $10M?

Answer 1

1.