Decision trees are models which allow you to both visualize and quantify a range of possible outcomes when faced with complex choices. These models incorporate the timing and estimated probability of outcomes along branches on a tree to help you identify the most promising path forward.
Review the following:
Real Options and the Value of Information
Did you know that roughly 60 percent of new restaurant businesses fail within the first three years of operation (Abrams, 2004)?
Suppose you have a close friend who is employed in a high-paying position in the banking industry with tremendous potential for her professional and financial growth. However, your friend wants to leave this position and start a little restaurant. It is your job to help your friend make a sound decision. What do you do?
Often, the valuations on which decisions are based require the input of information neither easily deduced nor accurately available. There are so many options and so little time. The values of these options can be clouded in uncertainty. The likelihood of each outcome—both those that are dependent and those that are independent—is shrouded in a variety of likely scenarios.
Like your friend, you must assess the value of certain options, including those choices foregone. If your friend, the restaurateur, leaves her job, what is the income she has given up? What is the probability that her business will flourish for a year or two years? What is the likelihood today that she will be in business three years from today (you would immediately think 40 percent)? What if she creates a great restaurant that is widely acclaimed, but the market, well beyond her control, suddenly crashes? How might you have incorporated that information in your forecast of probabilities?
As you can see, decision points combine with scenarios, including events beyond the chooser’s control, to increase the complexity of choosing. Fortunately you have a tool, scenario analysis, which works in conjunction with decision trees where multiple outcomes and the likelihood of those outcomes can be evaluated in light of an uncertain future and the need for a choice today. As much as you need to rationalize your choices and incorporate information accurately and reasonably, you must also learn to forecast reasonably, and identify those biases that undermine your choices.
Now assume your friend, Jennifer the banker (formerly a bank teller), has asked for your advice as to whether she should quit her job and pursue her passion in order to become a restaurateur.
Assume the following facts as well as the above information:
As a banker, Jennifer makes $135,000 a year with up to a 25 percent bonus. Her maximum raise per year is 10 percent (raises are skewed to capture inflation). She has $250,000 in savings. Her expenses are $5000 a month after taxes.
Jennifer is eligible for a promotion in twelve months; the promotion comes with a 50 percent increase in pay and 25 percent bonus. She is competing with three other employees for the position. If Jennifer does not receive the promotion, in all probability she will be considered for promotion to the same position after another twelve months, be asked to stay in her current role for the foreseeable future, or be asked to leave the bank.
Jennifer enjoys her current job but she wants to manage her own business at some point in her career. She is an avid chef, having had some experience in college and afterwards. She is also personally inclined towards more entrepreneurial ventures. Jennifer gets enormous personal value out of the pursuit of her personal and professional goals.
Jennifer’s current employer focuses exclusively on small- and medium-sized business clients along with their families. If Jennifer left the bank, her former employer would be a ready and willing source of financing with a reasonable business plan in place.
Opening a restaurant will require a $200,000 cash investment for capital improvements and materials. The bank normally provides new restaurants with access to a $100,000 rolling line of credit at an 8 percent cost for the first $50,000 and a 12 percent cost for the second $50,000.
The restaurant will, in the case of modest success, lose $25,000 in the first twelve months; generate a 20 percent net profit in months 13–24, and 25 percent in months 25–36.
About this Assignment
The goal of this assignment is to thoroughly analyze Jennifer's situation through use of a decision tree which you will create. Decision trees can be drawn by hand or created in any number of software tools including Microsoft Word and Excel
Choose a method for creating a decision tree. Download and review the decision tree template example offered on this page which you will use, along with your chosen method for decision tree creation, to address the following:
Map out the various scenarios that Jennifer faces—for example, bankruptcy, breakeven, modest success, home run—and produce a scenario model.
Assign probabilities to the various nodes and use the tools to offer the best advice you can.
State well-reasoned decisions about the market and Jennifer’s future prospects in your models.
Work backwards from assumption five in the above list of facts and determine, in terms of sales in dollars, how large the restaurant needs to be to break even.
Write a 3–4-page paper in Word format describing your decision making process, conclusions, and recommendations for Jennifer. Apply APA standards to citation of sources. Use the following file naming convention: LastnameFirstInitial_M4_A2.doc.
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Assignment 2 case solution Jennifer Decision Tree
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Assignment x xxxx solution xxxxxxxx Decision Tree
file1.doc preview (1252 words)
xxxxxxx Head: xxxxxxxx xxxx 1 DECISION TREE � PAGE \* xxxxxxxxxxx �2�
xxxxxxxxxx xx Banking on x xxxxx Award
xxxxxxxx is a banker xxxx xxxxxxxxxx potential xxx xxxxxxxxxxxx and xxxxxxxxx growth in the xxxxxxx sector. However, xxx xxx xx xxxxxxxxxxxxxxx xxxxxx and wants to xxxx a restaurant because xx her xxxx skills. It’x a crucial xxxxxxxx xxxx requires thorough xxxxxxxx xx xxx growth potential xx xxx xxxxxxxxxxx xxxxxxxxxx with xxx industry average xx 60 xxxxxxx xx xxx restaurants xxxxxxx within xxxxxxx xxxxx years xx xxxxxxxxxx xxxxxxxx xxxxxx xx xxxxxxxx xxxxx have to forgo her lucrative job xxx launching xxx own xxxxxxxxxxx this xxxxx xxxxxxxx xxxx xxx options that xx xx continue her xxx xx to start her
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|Real Options and the xxxxx of xxxxxxxxxxx|
|Did you xxxx xxxx xxxxxxx 60 percent of new xxxxxxxxxx businesses xxxx xxxxxx the first three xxxxx of operation (Abrams, xxxxxx|
|xxxxxxx xxx have a xxxxx friend xxx xx employed xx x high paying position in xxx xxxxxxx xxxxxxxx xxxx xxxxxxxxxx potential for both xxxxxxxxxxxx xxx financial xxxxxxx Nevertheless, your friend wants xx leave xxx start a little xxxxxxxxxxx xx is xxxx xxx xx help your friend xxxx x sound decision. What xx xxx xxx|
|Often xxx valuations on xxxxx decisions xxx xxxxx xxxxxxx the xxxxx xx information xxxxxxx easily xxxxxxx nor xxxxxxxxxx xxxxxxxxxx There xxx xx xxxx options xxx so xxxxxx time. xxx values xx these options xxx xx xxxxxxx in uncertainty. The xxxxxxxxxx xx each outcome—xxxx xxxxx xxxx are|
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