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8. Recommend a price and marketing strategy for the established automobile manufacturer seeking to enter the market for specialist competition motorcycles. Compare your recommendations to those for the automobile firm seeking to enter the volume small car market. 9. An engineering firm about to undertake a production run of 2000 items must decide whether to overhaul the production machinery. Because the machinery is quite old, the cost of an overhaul is uncertain. However, after the overhaul the failure rate for the machinery is certain to be 0.01. Without the overhaul, the machinery has a failure rate with the probability distribution given below. Each defective item costs the firm f6 in hand finishing. Failure rate Probability 0.01 0.5 0.02 0.2 0.03 0.1 0.04 0.1 0.05 0.1 Examination questions and answer notes 341 (a) Find the expected cost of overhaul that would make the risk- neutral decision-maker indifferent between overhauling or not. (b) The decision-maker decides to seek further information. Contact with the machinery supplier suggests an overhaul is equally likely to cost either f175 or 1225, depending on the problems encoun tered. Moreover a sample run of 10 items is produced, resulting in 2 defectives. Use this new information to re-assess the overhauling decision. (c) How would the decision be influenced by: (i) the firm's precarious financial position; (ii) the knowledge that the machinery is to be scrapped after the next production run. 10. 'Opportunity cost is both subjective and speculative. As such the concept of opportunity cost has no place in the scientific decision- making process.' Discuss. 11. (a) Briefly explain the significance of the firm's cost of capital. What are the factors determining that cost of capital, and how can that cost be estimated? (b) Given that debt finance is generally cheaper than equity finance, explain why the firm is unlikely to use solely debt finance to fund expansion. (c) A commodity broker is contemplating the acquisition of a new computer-driven management information system (MIS). The hardware for this would cost an initial f4 million, whilst software and staff training would cost f1 million for each of the first two years operation, and f200 000 per year thereafter. After six years, the system would be due for replacement. However scrapping the current (manual) system would save staff costs of f1.5 million each year. To finance the new investment the broker would use a combina- tion of debt and equity capital in the ratio 1:3. The broker can borrow at an interest rate of 10%, whilst interest paid can be set against the corporation tax liability (currently taxed at 30%). The broker is a listed company with a current share price of f3.00, and current dividend of 15 pence. Over the period the share price is expected to grow at an annual rate of 6%. Use the above information to evaluate investment in the new MIS, finding the net present value and internal rate of return on that investment. What other factors should the decision-maker take into account?1. Questions 1 and 2 are a 'spillover' from the previous year's course, and should only be answered when all else fails. 2. Without attending the course, and participating in a business game, it would be most unwise to answer this question. 4. This question requires a careful definition of uncertainty and explanat tion of the techniques used to make decisions under uncertainty. It is difficult to argue against the need to make probability estimates in the face of uncertainty, but caution needs to be expressed about the methods available. Expected profit requires definition and considera- tion as a decision objective, pointing out the circumstances in which it is appropriate (small sums of money or linear utility functions and repetitive decisions) and evaluating alternative criteria. Refer to Chapter 4. 5. Explain the criteria of minimising expected cost, and apply it to this problem. Calculate the expected cost with and without the revision course. Note that 'equally likely' implies a probability of 0.5 to each, so that the expected failure rate after the course is (0.05 x 0.5) + (0.10 x0.5) = 0.075. Then calculate the likelihood of two fails in a sample of 10 using the Binomial distribution and combine with the prior probabilities using Bayes Theorem to find posterior probabilities. Use these posterior probabilities to determine whether the course should run, using expected cost or opportunity loss as the decision criteria. List the assumptions made to answer the question, and assess their relevance in these circumstances. Refer to Chapter 4. 6. Examine the methods available for demand estimation, comparing and contrasting the explanatory and extrapolatery approaches. Dis- cuss the decision about resources to be devoted to demand estima- tion, primarily determined by the use to which forecasts are to be put. Explain what is meant by forecast reliability, and how this can be Examination questions and answer notes 343 estimated prior to forecast use. Refer to Chapter 5 and especially Application 5. 7. Explain what is meant by a new product, carefully defining the concept of 'newness', and examine the cost and demand estimation problems surrounding new product pricing. Analyse the importance of the competitive environment, and explain the factors determining whether a 'skimming' or 'penetration' policy should be used, using the example given in the question, and its implicit emphasis on the importance of entry conditions. Refer to Chapters 8 and 9. 8. Examine the role and consequences of advertising, contrasting the market expansion and redistributional implications of advertising. Outline the model of advertising as information, and consider the circumstances in which advertising information reduces the cost of search to the consumer. Refer to Chapter 10. 9. (a) The model outlined in Chapter 13 can be used to analyse the effects of an increase in interest rates, but note the qualifications to the model when compared to the evaluation methods encoun tered in practice. 9. (b) First explain the DCF and/or internal rate of return methods of investment appraisal, and then use discounting to evaluate the cash flow generated by the squash court. 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