Question
The Zephyr Software Company in Manchester currently has an option to purchase the rightsto a new piece of software with advanced AI capabilities. It is
The Zephyr Software Company in Manchester currently has an option to purchase the rightsto a new piece of software with advanced AI capabilities. It is now May 1st, and the currentprice is 2.2 million. Zephyr does not actually need the software until the beginning of July,but its top executives fear that another company might buy the rights between now and thebeginning of July. They assess that there is a 5% chance that a competitor will buy the rightsduring May. If this does not occur, they assess that there is a 10% chance that the competitorwill buy the rights during June. If Zephyr does not take advantage of its current option, it canattempt to buy the software rights at the beginning of June or the beginning of July, providedthey are still available.Zephyrs incentive for delaying the purchase is that its financial experts believe there is a goodchance that the price will fall significantly in one or both of the next two months. They assessthe possible price decreases and their probabilities in Tables 1 and 2. Table 1 shows theprobabilities of the possible price decreases during May. Table 2 lists the conditionalprobabilities of the possible price decreases in June, given the price decrease in May. Forexample, it indicates that if the price decrease in May is 60,000, then the possible pricedecreases in June are 0, 30,000, and 60,000 with respective probabilities 0.6, 0.2, and 0.2.Table 1: Distribution of Price Decrease in MayPrice Decrease Probability0 0.560,000 0.3120,000 0.2Table 2: Distribution of Price Decrease in JunePrice Decrease in May0 60,000 120,000JuneDecreaseProbability JuneDecreaseProbability JuneDecreaseProbability0 0.3 0 0.6 0 0.760,000 0.6 30,000 0.2 20,000 0.2120,000 0.1 60,000 0.2 40,000 0.1If Zephyr purchases the software rights, it believes it can generate 3 million in revenue fromthe new capabilities. But if it does not purchase the rights, Zephyr believes it can make650,000 from alternative software investments. What should the company do?
4a. Develop a decision tree on an Excel Spreadsheet that can be used to solve Zephyrsproblem. You can assume in this part of the problem that the company is using EMV (ofnet profit) as a decision criterion. Build the tree so that you can enter any values forprobabilities (in input cells) and automatically see the optimal EMV and optimal strategyfrom the tree. [10]b. Perform sensitivity analysis on the probabilities and prices to analyse the robustness ofyour recommendation to possible changes in these parameters. [7]c. In the report, summarise answers to the above questions and include anyrecommendations you would make to the company.
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