Variance Investigation under Uncertainty (Appendix) The internal auditor of Transnational Com- pany estimates the probability of its internal control procedure being in control to be 80 percent. She estimates the cost to conduct an investigation to find areas for improvement to be about $20,000 and the cost to revise and improve the internal control procedure to be approximately $50,000. The present value of savings from having the new procedure is expected to be $250,000.
Required
1. Construct a payoff table for the company to use in determining its best course of action.
2. What is the expected cost to the firm if it conducts an investigation? If it does not investigate? Should the firm investigate? Why or why not?
3. What is the expected value of perfect information?
Note: The expected value of perfect information (EVPI) is defined as the maximum value the manager would pay to have knowledge (i.e., certainty) of whether the process is in control or out of control. In the present context, the EVPI can be thought of as the difference between the expected cost with perfect information and the expected cost without perfect information. (To calculate the former, we need to choose for each possible state of nature the best course of action [decision] and then multiply the associated "cost" by the probability of that state of nature occurring. We then sum these resulting expected costs to get the expected cost with perfect information.) (Hint: For this problem, the expected cost under perfect information is $14,000.)