Decision Support Model Homework

HOMEWORK 2

Question 1:

Hana Semiconductor Ltd. is considering purchasing an insurance policy to insured its new factory from fire accident. The annual cost of the policy is Baht 500,000. The insurance policy will pay for all the damages if a fire accident happens. In case a minor fire accident happens with the probability of 0.03, the damage would be Baht 5,000,000. A major fire could happen with the probability of 0.01 and cause a damage of Baht 10,000,000.

Hana Semiconductor Ltd. has 2 choices: accept the insurance policy or decline the insurance policy

If the company accepts the insurance, first if will have to pay Baht 500,000. Then there also could be three scenarios: there could be a minor fire with a probability of 0.03, and the company receives a Baht 5,000,000 reimbursement from the insurance company. Or there could be major fire with a probability of 0.01 and company receives a Baht 10,000,000 reimbursement from the insurance company. Or there could be no fire and the company receives nothing.

If the company denies the insurance, there could be 3 scenarios: there could be a minor fire with a probability of 0.03, which causes the company a damage of Baht 5,000,000. Or there could be major fire with a probability of 0.01 and causes the company a damage of Baht 10,000,000. Or there could be no fire and the company doesn't have to pay anything.

Using Tree Plan on Excel, we have come up with the below decision tree:

Let p1 be the probability of having a major fire, p2 be the probability of having a minor fire and p3 be the probability of having no fire.

Let E1 be the Expected Value of the choice purchasing insurance and E2 be the Expected Value of the choice denying insurance.

Using the Expected Monetary Value approach, we have:

E1 = -500,000 + p1*10,000,000 + p2*5,000,000 + p3*0

E2 = p1*(-10,000,000) + p2*(-5,000,000) + p3*0

With the probability provided, we know that E1 is -250,000 and E2 is -250,000 too. This means whether the company buys the insurance or not, the company expects a loss of Baht 250,000.

However, we suggest that Hana Semiconductor should buy this insurance, because if it buys the insurance, the maximum possible loss is only Baht 500,000; while if it doesn't buy the insurance, the maximum possible loss is Baht 10,000,000. So buying the insurance is less risky to the company.

Question 2:

Our company is thinking about outsourcing our company's IT support services. Currently the IT service costs are 600,000 USD per year. After many research, we are considering a 5-year contract with 2 providers: A and B.

- Provider A is a large company with a strong reputation for reliability. They will increase the quality of service and maintain our current costs.

- Provider B is a smaller and newer company. They will also increase the quality of service but at the same time they will reduce the costs over the 5 years, resulting in a NVP savings of 500,000 USD. But there is a chance they may fail with the probability of 2% and if they do, our total NPV costs over 5 years would be 4,000,000

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