Advanced: Machine hire decision based on uncertain demand and calculation of maximum price to pay for perfect information Siteraze Ltd is a company which engages in site clearance and site preparation work. Information concerning its operations is as follows:

(i) It is company policy to hire all plant and machinery required for the implementation of all orders obtained, rather than to purchase its own plant and machinery.

(ii) Siteraze Ltd will enter into an advance hire agreement contract for the coming year at one of three levels-high, medium or low, which correspond to the requirements of a high, medium or low level of orders obtained.

(iii) The level of orders obtained will not be known when the advance hire agreement contract is entered into. A set of probabilities have been estimated by management as to the likelihood of the orders being at a high, medium or low level.

(iv) Where the advance hire agreement entered into is lower than that required for the level of orders actually obtained, a premium rate must be paid to obtain the additional plant and machinery required.

(v) No refund is obtainable where the advance hire agreement for plant and machinery is at a level in excess of that required to satisfy the site clearance and preparation orders actually obtained.

A summary of the information relating to the above points is as follows:

Variable cost (as percentage of turnover) 70%
Required: Using the information given above:

(a) Prepare a summary which shows the forecast net margin earned by Siteraze Ltd for the coming year for each possible outcome.
(6 marks)

(b) On the basis of maximizing expected value, advise Siteraze whether the advance contract for the hire of plant and machinery should be at the low, medium or high level. (5 marks)

(c) Explain how the risk preferences of the management members responsible for the choice of advance plant and machinery hire contract may alter the decision reached in

(b) above.

(d)Siteraze Ltd are considering employing a market research consultant who will be able to say with certainty in advance of the placing of the plant and machinery hire contract, which level of site clearance and preparation orders will be obtained. On the basis of expected value, determine the maximum sum which Siteraze Ltd should be willing to pay the consultant for this information.

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Plant and machinery hire costs Level of orders Advance Conversion Turnover Probability (000) hire premium (000) (000) High 15000 0.25 2300 Medium 8 500 0.45 1500 Low 4000 0.30 1000 Low to 850 medium Medium to high Low to high 1300 2150