• Exercise 1

Six months ago, Reynolds Properties purchased an option to buy a tract of land that has the potential of becoming very desirable commercial property. Currently, another real estate investment firm has offered to purchase Reynolds option. If Reynolds sells its option, it will experience a $250,000 profit. On the other hand, if Reynolds keeps the option, the success of the project depends upon what happens to the real estate market over the next year. In the worst case, Reynolds could lose $1.5 million, while in the best case Reynolds could have a $4 million profit. The decision alternatives, states of nature and payoffs in $ millions are as follows:

Decision Alternative		State of Nature
	Market Down	Market Steady	Sell option
Sell option	0.25	0.25	0.25
Keep option	-1.5	1	4

1. If Reynolds managers believe that the probabilities of the real estate market being down, steady, and up are 0.6, 0.3, and 0.1, respectively, what decision alternative is recommended? What is the expected value of this recommendation? Draw a decision tree.
2. Suppose that three probabilities are revised to 0.5, 0.3 and 0.2. What should Reynolds do? Repeat this question if the three probabilities are revised to 0.4, 0.4 and 0.2. What do the results suggest about Reynolds decision?