Problem 4-15

The Lake Placid Town Council decided to build a new community center to be used for conventions, concerts, and other public events, but considerable controversy surrounds the appropriate size. Many influential citizens want a large center that would be a showcase for the area. But the mayor feels that if demand does not support such a center, the community will lose a large amount of money. To provide structure for the decision process, the council narrowed the building alternatives to three sizes: small, medium, and large. Everybody agreed that the critical factor in choosing the best size is the number of people who will want to use the new facility. A regional planning consultant provided demand estimates under three scenarios: worst-case, base-case, and best-case. The worst-case scenario corresponds to a situation in which tourism drops substantially; the base-case scenario corresponds to a situation in which Lake Placid continues to attract visitors at current levels; and the best-case scenario corresponds to a substantial increase in tourism. The consultant has provided probability assessments of 0.10, 0.60, and 0.30 for the worst-case, base-case, and best-case scenarios, respectively.

The town council suggested using net cash flow over a 5-year planning horizon as the criterion for deciding on the best size. The following projections of net cash flow (in thousands of dollars) for a 5-year planning horizon have been developed. All costs, including the consultant’s fee, have been included.

 Demand Scenario

Center Size

Worst-CaseBase-CaseBest-CaseSmall400500660Medium-250650800Large-400580990

1. What decision should Lake Placid make using the expected value approach?Medium or Large  
2. Identify the risk profiles for the medium and large alternatives.(i)(ii)(iii)Risk profile for medium-size community center:  Risk profile for large-size community center:  Given the mayor’s concern over the possibility of losing money and the result of part (a), which alternative would you recommend? 
3. Compute the expected value of perfect information.EVPI = $ fill in the blank 5Do you think it would be worth trying to obtain additional information concerning which scenario is likely to occur?Best decision: Yes  
4. Suppose the probability of the worst-case scenario increases to 0.2, the probability of the base-case scenario decreases to 0.5, and the probability of the best-case scenario remains at 0.3. What effect, if any, would these changes have on the decision recommendation? 
5. The consultant has suggested that an expenditure of $150,000 on a promotional campaign over the planning horizon will effectively reduce the probability of the worst-case scenario to zero. If the campaign can be expected to also increase the probability of the best-case scenario to 0.4, is it a good investment?The input in the box below will not be graded, but may be reviewed and considered by your instructor.