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UNIVERSITY OF CALIFORNIA HAAS SCHOOL OF BUSINESS EWMBA 201A—Economic Analysis for Business Decisions Fall 2007 Professor Catherine Wolfram Midterm Review Question Solutions: Decision Analysis [ Based on Fall 2002 Midterm. Numbers in square brackets reflect points out of roughly 80 total. ] 1) You are the Chief Information Officer for a medium-sized manufacturing company and you are debating adopting a new Enterprise Resource Planning (ERP) software product created by the company Monocle. You know that the cost of adopting Monocle’s ERP (including the actual software purchase price, training for your employees and slowed production as you transition from your old software system) will be $100 million. The value of adopting Monocle’s ERP to your company depends on the number of your suppliers who also adopt it. You know that your major supplier will adopt it for sure. If none of your other suppliers adopt it, the value to your company of adopting Monocle’s ERP (not including the adoption costs) is $80 million. You believe that there’s a 20% chance that only your major supplier will adopt. You believe, however, that there’s a 40% chance that one-third of your remaining suppliers will adopt it and a 40% chance that all of your remaining suppliers will adopt it. If everyone adopts it, the value to your company is $120 million and if only one third of the remaining suppliers adopt it, the value is $100 million (neither of these numbers include the adoption costs). If you don’t adopt Monocle’s ERP, you will continue patching together various database and input control programs, which costs your company nothing but adds no value. (1a) [10] Should your company adopt Monocle’s ERP (assuming it is risk neutral)? Draw the decision tree. Solution (1a) The decision tree looks like tree 1(a). The EV of adopting ERP is $4 million, so yes you should adopt.
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EWMBA 201a Fall 2007—Prof. Wolfram 2 (1b) [5] Could your answer to (a) change if your company were risk averse? Solution (1b) Yes, the answer could change. Adopting the ERP amounts to a gamble with a positive EV, but the possibility of losses. Declining such gambles is consistent with risk aversion. (1c) [10] Assume again that you are risk neutral. Monocle has offered to put you in touch with a network of suppliers all of whom have already adopted their ERP. If you take Monocle up on this offer, you obtain the same $120 million in value (before costs) that you would have if all your existing suppliers switched. Switching to Monocle’s network of suppliers imposes additional costs of $7 million on your company. Given this, how much should you be willing to pay Monocle to assist you in switching to their supplier network? Solution (1c)
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This note was uploaded on 09/21/2009 for the course EWMBA 201A taught by Professor Wolfram during the Fall '07 term at Berkeley.

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