Case 6.2

Westhouser Paper Company

The Westhouser Paper Company in the state of Washington currently has an option to purchase a piece of land with good timber forest on it. It is now May 1, and the current price of the land is $2.2 million. Westhouser does not actually need the timber from this land until the beginning of July, but its top executives fear that another company might buy the land between now and the beginning of July. They assess that there is a 5% chance that a competitor will buy the land during May. If this does not occur, they assess that there is a 10% chance that the competitor will buy the land during June. If Westhouser does not take advantage of its current option, it can attempt to buy the land at the beginning of June or the beginning of July, provided that it is still available.

Westhouser's incentive for delaying the purchase is that its financial experts believe there is a good chance that the price of the land will fall significantly in one or both of the next two months. They assess the possible price decreases and their probabilities inTables 6.2and6.3.Table 6.2shows the probabilities of the possible price decreases during May.Table 6.3lists theconditionalprobabilities of the possible price decreases in June,giventhe price decrease in May. For example, it indicates that if the price decrease in May is $60,000, then the possible price decreases in June are $0, $30,000, and $60,000 with respective probabilities 0.6, 0.2, and 0.2.

Table6.2

Distribution of Price Decrease in May

Price DecreaseProbability$00.5$60,0000.3$120,0000.2

Table6.3

Distribution of Price Decrease in June

Price Decrease in May$0$60,000$120,000June DecreaseProbabilityJune DecreaseProbabilityJune DecreaseProbability$00.3$00.6$00.7$60,0000.6$30,0000.2$20,0000.2$120,0000.1$60,0000.2$40,0000.1

If Westhouser purchases the land, it believes that it can gross $3 million. (This does not count the cost of purchasing the land.) But if it does not purchase the land, Westhouser believes that it can make $650,000 from alternative investments. What should the company do?