# Assignment 2

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.
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
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.
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 .

2

>Notes

of Information

id you know that roughly

percent of new restaurant businesses fail within the first three years of operation (Abrams, 200

)?

here 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.

)     As a banker, Jennifer makes \$1

5,000 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.

percent cost for the first \$50,000 and a

percent cost for the second \$50,000.

## Base Case

: The numbers are samples FOR ONE YEAR and shows how large a “huge success” must be to make Jennifer indifferent in the short term. Your cash flows will need to incorporate at least three years (and likely more!).

.com

0 1200000

0 -25000

0
0 0
1
112500

0

0.3333333333

-60000

-60000 112500 0

0.3333333333

-60000

0

Value

0 TreePlan 0 0 0 D 2 1 2 0 0 0

1

1 0 0 E 3 6

8 0 0 7 5

2 0 0 E 3 3 4 5 0 0

5

3 2 T 0 0 0 0 0 0

4 2 T 0 0 0 0 0 0 22 9
5 2 T 0 0 0 0 0 0

9

6 1 T 0 0 0 0 0 0 2 9
7 1 T 0 0 0 0 0 0 7 9
8 1 T 0 0 0 0 0 0 12 9
 Sample only. You may select other options based on your model, financing, income and expense projections NOT E Jennifer’s Career 0.1 www. TreePlan Huge Success 1200000 0.3 Open a restaurant Modest Success -25000 -260000 112500 0.6 Closure 0.3333333333 Promotion -60000 \$ 202,500 Stay at the bank Stay in current job \$ 135,000 Termination \$ – 0 ID Name Prob Pred Kind NS S1 S2 S3 S4 S5 Row Col Mark 14 7 22 17 9 27

&l&bTreePlan Tryout, Only For Evaluation&r&bwww.TreePlan.com
Jennifer still has expenses if she stays at the bank!

## TreePlan Help

selected node.

branch.

with one to five successor branches.

branch.

(In large trees, this option may not be available.)

formatting, select the appropriate option button.

EXP(-X/RT) and X=-LN((A-U)/B)*RT, and for the

.

Internet: middleton@usfca.edu

Michael R. Middleton

&A
Page &P

## Hints

*

*

*

*

*

*

*

* click OK

*

*

* click OK

*

*

* click OK

*

*

* click OK

*

*

*

*

*

*

*

*

*

*

*

*

* click OK

 Hints: TreePlan and Excel 5 Hiding Selected Cells To hide all rollback EV/CE cells: select one rollback EV/CE cell from the Tools menu choose Decision Tree… in the TreePlan…Select dialog box select (Cells) Rollback EVs/CEs click OK from the Format menu choose Cells…; in the Format Cells dialog box select the Number tab at the bottom of the Number tab select the Code field type three semicolons as a custom code Use similar steps to hide all cells of any specific type. Pasting Into Word To paste a copy of a decision tree into Word: from Excel’s Tools menu select Options…; in the Options dialog box select the View tab in the View tab clear the check boxes for Formulas and Gridlines from Excel’s Edit menu select Go To… in the Go To list box select TreeDiagram hold down the shift key and from Excel’s Edit menu select Copy Picture… in the Copy Picture dialog box select (Appearance) As Shown when Printed switch from Excel to Word select an empty paragraph from Word’s Edit menu select Paste Probability Sensitivity Analysis (Two Branches) To see how expected value of the optimal strategy depends on a probability of interest: select the probability cell of the other branch of the event set enter the formula “=1-P” where P is a reference to the probability cell of interest enter a list of probabilities in a column select the cell in the row above the first probability in the column to the right enter the formula “=R” where R is a reference to the rollback cell of the initial decision node select the entire data table which includes the blank cell above the probability list, the cells containing the list of probabilities, the cell with the formula referencing the rollback cell, and the empty cells below the formula cell from the Data menu select Table… in the Table dialog box select the Column Input Cell field enter a reference to the probability cell of interest

&A
Page &P

Assignment 2: Banking on a Beard Award

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

Review the following:

Abrams, R. (2004, July 5). Focus on success, not failure. USA Today. Retrieved from:

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.

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/

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.

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 .

Order your essay today and save 25% with the discount code: GREEN

## Order a unique copy of this paper

600 words
We'll send you the first draft for approval by September 11, 2018 at 10:52 AM
Total price:
\$26