James Middleton is considering the potential for success in a side business by opening a bicycle store in a local mall complex. The proposed store would cater to a growing trend in cycling with bicycle sales, parts and add-on equipment sales, rentals, and service and repair. Two spaces, one large and one small, with ideal locations in the complex are currently available. Both require minimum 5-year leases. Profits for the venture will depend on the size of the store and whether the market is favorable or unfavorable for the products and services proposed. Middelton is also considering hiring a small market research firm to conduct a study to predict the likelihood of a favorable or unfavorable demand reaction to the proposed business.
James Middelton has done some preliminary analysis concerning the potential profitability of the store. If he opens a large store, he estimates that he would earn $60,000 if the market is favorable and would lose $40,000 if the market is unfavorable. Opening a small store should return a $30,000 profit in a favorable market and a $10,000 loss in an unfavorable market. Mr. Middelton believes that, at the present time, there is only a 50-50 chance that the market will be favorable. The market research firm will charge him $5,000 for the research on his project. The firms' track record for similar research study projects indicates that there is a 0.6 probability that the study for the bicycle store will be favorable. Furthermore, there is a 0.9 probability that the market will actually be favorable given a favorable result from the study. However, the research firm has cautioned James Middelton that there is only a 0.12 probability of a favorable market if the research results are not favorable.
Q1. Develop a decision tree or complete payoff tables to represent the alternatives and outcomes for this problem.
Q2. Use the expected value approach to recommend which alternative James Middelton should follow in order to maximize expected profit contribution or return. Provide a complete narrative of all steps taken in the decision process and the justification for the indicated recommendation.
Q3. If the probability of a favorable market research study result is incorrect, determine and explain how far this factor could deviate before your recommendation would change.