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. Â

Abrams, R. (2004, July 5). Focus on success, not failure. USA Today. Retrieved from: http://www.usatoday.com/money/smallbusiness/columnist/abrams/2004-05-06-success_x.htm

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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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—even Google Docs has a resource. Through Internet research you will find there are several different decision tree tools on the market. You may want to try a free trial version application or use software that you have used in the past to create your decision tree. To get started, here are two free options you might want to investigate:

• TreeMapGViz which is a Google Gadget that allows treemap generation in Google Docs. The treemap is also available through Google's visualization API.
• TreePlan–Decision Trees which is an Excel add-in that enables and automates the creation of decision trees within Microsoft Excel. This is the tool chosen as an example for taking you through the steps to complete a decision tree. If you chose to use this tool, begin by downloading the free trial for this add-in from the following link: http://www.treeplan.com/

Note:You can help your fellow students locate those decision tree tools you find interesting by posting product links in theWebliography.

Assignment Details

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.

Complete your decision tree and save it as a PDF document.

 

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.

By Wednesday, August 22, 2012, deliver your PDF format decision tree and your written assignment to the M4: Assignment 2 Dropbox.

 

Assignment 2 Grading Criteria	Maximum Points
Mapped out the various scenarios that Jennifer faces and produced a scenario model.	12
Assigned probabilities to the various nodes and used the tools to offer the best advice.	20
Stated well-reasoned decisions about the market and Jennifer’s future prospects in the models.	16
Determined, in terms of sales in dollars, how large the restaurant needs to be to break even.	16
Wrote in a clear, concise, and organized manner; demonstrated ethical scholarship in accurate representation and attribution of sources; displayed accurate spelling, grammar, and punctuation.	16
Total