Starting Right Corporation Questions

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DISCUSSION QUESTIONS AND PROBLEMS
117
Problems
3-17 Kenneth Brown is the principal owner of Brown Oil,
Inc. After quitting his university teaching job, Ken
has been able to increase his annual salary by a fac-
tor of over 100. At the present time, Ken is forced
to consider purchasing some more equipment for
Brown Oil because of competition. His alternatives
are shown in the following table:
3-20 Mickey Lawson is considering investing some
money that he inherited. The following payoff ta-
ble gives the profits that would be realized during
the next year for each of three investment alterna-
tives Mickey is considering:
STATE OF NATURE
DECISION
ALTERNATIVE
GOOD
ECONOMY
POOR
ECONOMY
Stock market
80,000
FAVORABLE UNFAVORABLE
MARKET MARKET
($)
($)
EQUIPMENT
Bonds
-20,000
20,000
23,000
0.5
Sub 100
300,000
-200,000
30,000
23,000
0.5
CDs
Probability
Oiler J
250,000
-100,000
Texan
75,000
-18,000
(a) What decision would maximize expected
profits?
(b) What is the maximum amount that should be
paid for a perfect forecast of the economy?
For example, if Ken purchases a Sub 100 and if
there is a favorable market, he will realize a profit of
$300,000. On the other hand, if the market is unfa-
vorable, Ken will suffer a loss of $200,000. But Ken
has always been a very optimistic decision maker.
(a) What type of decision is Ken facing?
(b) What decision criterion should he use?
(c) What alternative is best?
3-18 Although Ken Brown (discussed in Problem 3-17) is
the principal owner of Brown Oil, his brother Bob is
credited with making the company a financial suc-
cess. Bob is vice president of finance. Bob attributes
his success to his pessimistic attitude about business
and the oil industry. Given the information from
Problem 3-17, it is likely that Bob will arrive at a dif-
ferent decision. What decision criterion should Bob
use, and what alternative will he select?
• 3-19 The Lubricant is an expensive oil newsletter to which
many oil giants subscribe, including Ken Brown (see
Problem 3-17 for details). In the last issue, the letter
described how the demand for oil products would be
extremely high. Apparently, the American consumer
will continue to use oil products even if the price of
these products doubles. Indeed, one of the articles in
the Lubricant states that the chance of a favorable
market for oil products was 70%, while the chance
of an unfavorable market was only 30%. Ken would
like to use these probabilities in determining the best
decision.
3-21 Develop an opportunity loss table for the investment
problem that Mickey Lawson faces in Problem 3-20.
What decision would minimize the expected oppor-
tunity loss? What is the minimum EOL?
3-22 Allen Young has always been proud of his personal
investment strategies and has done very well over
the past several years. He invests primarily in the
stock market. Over the past several months, how-
ever, Allen has become very concerned about the
stock market as a good investment. In some cases, it
would have been better for Allen to have his money
in a bank than in the market. During the next year,
Allen must decide whether to invest $10,000 in the
stock market or in a certificate of deposit (CD) at an
interest rate of 9%. If the market is good, Allen be-
lieves that he could get a 14% return on his money.
With a fair market, he expects to get an 8% return.
If the market is bad, he will most likely get no re-
turn at all—in other words, the return would be 0%.
Allen estimates that the probability of a good market
is 0.4, the probability of a fair market is 0.4, and the
probability of a bad market is 0.2, and he wishes to
maximize his long-run average return.
(a) Develop a decision table for this problem.
(b) What is the best decision?
3-23 In Problem 3-22, you helped Allen Young determine
the best investment strategy. Now, Allen is thinking
about paying for a stock market newsletter. A friend
of Allen said that these types of letters could predict
very accurately whether the market would be good,
fair, or poor. Then, based on these predictions, Allen
could make better investment decisions.
(a) What decision model should be used?
(b) What is the optimal decision?
c) Ken believes that the $300,000 figure for the Sub
100 with a favorable market is too high. How
much lower would this figure have to be for Ken
to change his decision made in part (b)?
Note: means the problem may be solved with QM for Windows; means
the problem may be solved with Excel QM; and means the problem may be solved with QM for Windows and/or Excel QM.
CASE STUDY
125
Case Study
of 5 years. Investors in preferred stock should see their initial
investment increase by a factor of 4 with a good market or see
the investment worth only half of the initial investment with an
unfavorable market. The common stock had the greatest poten-
tial. The initial investment was expected to increase by a factor
of 8 with a good market, but investors would lose everything
if the market was unfavorable. During the next 5 years, it was
expected that inflation would increase by a factor of 4.5% each
year.
Starting Right Corporation
After watching a movie about a young woman who quit a suc-
cessful corporate career to start her own baby food company,
Julia Day decided that she wanted to do the same. In the movie,
the baby food company was very successful. Julia knew, how-
ever, that it is much easier to make a movie about a successful
woman starting her own company than to actually do it. The
product had to be of the highest quality, and Julia had to get the
best people involved to launch the new company. Julia resigned
from her job and launched her new company–Starting Right.
Julia decided to target the upper end of the baby food mar-
ket by producing baby food that contained no preservatives but
had a great taste. Although the price would be slightly higher
than for existing baby food, Julia believed that parents would
be willing to pay more for a high-quality baby food. Instead of
putting baby food in jars, which would require preservatives to
stabilize the food, Julia decided to try a new approach. The baby
food would be frozen. This would allow for natural ingredients,
no preservatives, and outstanding nutrition.
Getting good people to work for the new company was also
important. Julia decided to find people with experience in fi-
nance, marketing, and production to get involved with Starting
Right. With her enthusiasm and charisma, Julia was able to find
such a group. Their first step was to develop prototypes of the
new frozen baby food and to perform a small pilot test of the
new product. The pilot test received rave reviews.
The final key to getting the young company off to a good
start was to raise funds. Three options were considered: corpo-
rate bonds, preferred stock, and common stock. Julia decided
that each investment should be in blocks of $30,000. Further-
more, each investor should have an annual income of at least
$40,000 and a net worth of $100,000 to be eligible to invest in
Starting Right. Corporate bonds would return 13% per year for
the next 5 years. Julia furthermore guaranteed that investors in
the corporate bonds would get at least $20,000 back at the end
Discussion Question
1. Sue Pansky, a retired elementary school teacher, is con-
sidering investing in Starting Right. She is very conserva-
tive and is a risk avoider. What do you recommend?
2. Ray Cahn, who is currently a commodities broker, is
also considering an investment, although he believes that
there is only an 11% chance of success. What do you
recommend?
3. Lila Battle has decided to invest in Starting Right. While
she believes that Julia has a good chance of being success-
ful, Lila is a risk avoider and very conservative. What is
your advice to Lila?
4. George Yates believes that there is an equally likely chance
for success or failure. What is your recommendation?
5. Peter Metarko is extremely optimistic about the market
for the new baby food. What is your advice for Pete?
6. Julia Day has been told that developing the legal docu-
ments for each fund-raising alternative is expensive. Julia
would like to offer alternatives for both risk-averse and
risk-seeking investors. Can Julia delete one of the finan-
cial alternatives and still offer investment choices for risk
seekers and risk avoiders?
Case Study
Toledo Leather Company
The Toledo Leather Company has been producing leather
goods for more than 30 years. It purchases prepared hides from
tanners and produces leather clothing accessories such as wal-
lets, belts, and handbags. The firm has just developed a new
leather product and has prepared a 1-year production and sales
plan for it. The new product is best described as a combination
billfold, key case, and credit card carrier. As company presi-
dent Peggy Lane has noted, “It is a super carryall for small
this-and-that.” Lane has placed her administrative assistant,
Harold Hamilton, in charge of the project.
Hamilton has established that material and variable over-
head for the carryall should be about $1.50 per case over the
next year given a 5-day week and no overtime. Unit labor and
machining costs, however, depend on the choice of machine that
will be used for production. Hamilton has narrowed the choice
down to two specialized pieces of equipment. Machine 1 is a
semi-automated machine that will cut the material to the size
needed for one unit and also will sew it, install the rings and
snaps, and emboss it with two types of designs. This machine
costs $250,000 and will add $2.50 per case to the average vari-
able cost for labor and other machine-related costs. This piece
of equipment has a production capacity of 640 units per day.
However, estimated downtime for maintenance and repairs is
12.5% (1/8 of the total time).
Machine 2 is fully automated. It cuts, sews, and installs
rings and snaps and is capable of embossing the case with three
types of designs. This machine costs $350,000 and will add
$1.75 per case to the average variable cost for labor and other
machine-related costs. Machine 2 has a higher production ca-
pacity (estimated at 800 units per day) than the semi-automated
118
CHAPTER 3. DECISION ANALYSIS
(a) What is the most that Allen would be willing to
pay for a newsletter?
(b) Allen now believes that a good market will give
a return of only 11% instead of 14%. Will this
information change the amount that Allen would
be willing to pay for the newsletter? If your an-
swer is yes, determine the most that Allen would
be willing to pay, given this new information.
: 3-24 Today’s Electronics specializes in manufacturing
modern electronic components. It also builds the
equipment that produces the components. Phyl-
lis Weinberger, who is responsible for advising the
president of Today’s Electronics on electronic manu-
facturing equipment, has developed the following
table concerning a proposed facility:
spread to manufacture each month. The probability
that the demand will be six cases is 0.1, seven cases
is 0.3, eight cases is 0.5, and nine cases is 0.1. The
cost of every case is $45, and the price that Jason
gets for each case is $95. Unfortunately, any cases
not sold by the end of the month are of no value, due
to spoilage. How many cases of cheese should Jason
manufacture each month?
2:3-27 Farm Grown, Inc., produces cases of perishable food
products. Each case contains an assortment of veg-
etables and other farm products. Each case costs $5
and sells for $15. If there are any cases not sold by
the end of the day, they are sold to a large food pro-
cessing company for $3 a case. The probability that
daily demand will be 100 cases is 0.3, the probabil-
ity that daily demand will be 200 cases is 0.4, and
the probability that daily demand will be 300 cases
is 0.3. Farm Grown has a policy of always satisfying
customer demands. If its own supply of cases is less
than the demand, it buys the necessary vegetables
from a competitor. The estimated cost of doing this
is $16 per case.
(a) Draw a decision table for this problem.
(b) What do you recommend?
PROFIT ($)
STRONG FAIR POOR
MARKET MARKET MARKET
550,000
300,000
110,000
129,000
-310,000
-100,000
Large facility
Medium-sized
facility
Small facility
No facility
200,000
0
100,000
0
-32,000
0
(a) Develop an opportunity loss table.
(b) What is the minimax regret decision?
Q:3-25 Brilliant Color is a small supplier of chemicals and
equipment that are used by some photographic
stores to process 35mm film. One product that Bril-
liant Color supplies is BC-6. John Kubick, president
of Brilliant Color, normally stocks 11, 12, or 13
cases of BC-6 each week. For each case that John
sells, he receives a profit of $35. Like many photo-
graphic chemicals, BC-6 has a very short shelf life,
so if a case is not sold by the end of the week, John
must discard it. Since each case costs John $56, he
loses $56 for every case that is not sold by the end
of the week. There is a probability of 0.45 of selling
11 cases, a probability of 0.35 of selling 12 cases,
and a probability of 0.2 of selling 13 cases.
(a) Construct a decision table for this problem.
Include all conditional values and probabilities
in the table.
(b) What is your recommended course of action?
(c) If John is able to develop BC-6 with an ingredi-
ent that stabilizes it so that it no longer has to be
discarded, how would this change your recom-
mended course of action?
2:3-28 In Problem 3-27, Farm Grown, Inc., has reason to
believe the probabilities may not be reliable due
to changing conditions. If these probabilities are
ignored, what decision would be made using the op-
timistic criterion? What decision would be made us-
ing the pessimistic criterion?
: 3-29 Mick Karra is the manager of MCZ Drilling Prod-
ucts, which produces a variety of specialty valves for
oil field equipment. Recent activity in the oil fields
has caused demand to increase drastically, and a
decision has been made to open a new manufactur-
ing facility. Three locations are being considered,
and the size of the facility would not be the same
in each location. Thus, overtime might be necessary
at times. The following table gives the total monthly
cost (in $1,000s) for each possible location under
each demand possibility. The probabilities for the
demand levels have been determined to be 20% for
low demand, 30% for medium demand, and 50% for
high demand.
DEMAND DEMAND IS DEMAND
IS LOW MEDIUM IS HIGH
85
110
150
Ardmore, OK
Sweetwater, TX
Lake Charles, LA
100
140
90
110
120
130
:3-26 Megley Cheese Company is a small manufacturer of
several different cheese products. One of the prod-
ucts is a cheese spread that is sold to retail outlets.
Jason Megley must decide how many cases of cheese
(a) Which location would be selected based on the
optimistic criterion?
(b) Which location would be selected based on the
pessimistic criterion?

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