Module: business decision making

Question 4

The business manager of Tolkien Transport wishes to analyse three strategic options available to the company (Cost-cutting; Diversification; Expansion) under four possible UK macroeconomic conditions: Recession, Low Growth, Medium Growth and High Growth. He has summarised available information in the following pay-off matrix (with impact on company profits in the next year in £000s).

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  Macroeconomic Conditions
  Recession Low Growth Medium Growth High Growth
Cost-Cutting 100 130 170 200
Diversification -120 50 240 300
Expansion -250 30 300 500
  • What is the difference between risk and uncertainty? Illustrate with examples of business decisions.
  • Which option should Tolkien Transport choose based on of the following criteria? Indicate what attitude to risk each represents. i) Maximax ii) Minimax
  • Construct a potential regret matrix and use it to determine the best option according to the minimax regret criterion.
  • The business manager decides to access the latest macroeconomic predictions from the Bank of England. This provides him with the following probabilities: Recession (15%), Low Growth (30%), Medium Growth (35%), and High Growth (20%). Which option is preferred according to the expected monetary value (EMV) criterion? What attitude to risk does this represent?
  • Tom Tolkien, the CEO, is not happy with the quality of information being presented by his business manager. He asks the best economic consultancy firm in the country to provide an accurate macroeconomic forecast, which they guarantee would be 100% accurate. What is the most that Tolkien Transport should be willing to pay the research firm for this information (in other words what is the value of perfect information concerning the state of the economy)?
  • Tolkien Transport is facing increasing price competition from its big local rival in Yorkshire, Lewis Lorries. Tolkien’s CEO is interested in using game theory (in particular, the ‘prisoners’ dilemma’ game) to model decision making in this duopoly market. Explain and illustrate the key aspects of the ‘prisoners’ dilemma’ game, its key assumptions and how the CEO might use it to model his rivalry with Lewis Lorries.

 

 

Question 5

Assume that the income statement for Tolkien Transport last month is as follows:

 

Revenue (500 customers*£2000) £1,000,000
Less variable expenses £410,000
Contribution Margin £590,000
Fixed Costs £530,000
Net Profit £60,000

Note: The revenue given is calculated by multiplying number of customers last month (500) by £2,000 the average price for transportation services

Required:

  • Calculate the break-even point in units and in pounds last month.
  • How many customers would Tolkien Transport need to generate a profit of £119,000?
  • Compute the company’s margin of safety last month in both £ pound and percentage terms.
  • If revenue increases by £300,000 this month and there is no change in fixed costs, by how much would you expect profit to increase? (Do not prepare a profit and loss account; use the CM ratio to compute your answer.)
  • Refer to the original data. Tolkien Transport’s marketing team is convinced that a 15% reduction in the selling price would cause customer numbers this month to increase by 150 units. Calculate the impact on monthly profit.
  • Using the data from part (last part(fourth question), calculate the price elasticity of demand for its transportation service (based on a 15% reduction from the current selling price).
  • Calculate the profit-maximising mark-up on variable costs and use this to estimate the profit-maximising price for the transportation service. Based on this, what advice would you give Tolkien?
  • The absorption costing approach represents an alternative cost-plus pricing method. Explain how Tolkien would could this approach to determine the price of its transportation service, highlighting the advantages and disadvantages compared to the pricing method outlined in part

 

 

 

 

 

 

Question 6

 

Tolkien Transport is planning a refurbishment of its depot in Leeds, which will involve investment in new garage and repair facilities to speed servicing of vehicles. After initial screening, two alternative designs have been identified (labelled here A and B) and you are asked to undertake an investment appraisal of the two identified options, which are mutually exclusive. The assumption is that they both have an eight-year life and that there is some salvage value at the end of Year 8; for Option A this is £40,000 and Option B, £30,000. The initial outlay (in Year 0) required for each option varies and they will yield different levels of cash flows over their eight-year lives which arises from the labour and time savings from using the new facilities. Tolkien Transport wishes to use an 8% discount rate for Option A, but a 10% discount rate for Option B which uses an innovative design that is considered riskier. For Option A, there will be a need for further investment in Year 5 to update equipment; this is not the case for Option B. The net annual cash flows (in £000s) of the two options under consideration are as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Option A -200 60 60 60 60 -50 70 70 50
Option B -300 40 50 60 60 90 90 80 60
  • Estimate the payback period for each option. Suggest which of them (if any) is worthwhile if it is the company’s policy not to take any option with a payback period longer than 5 years.
  • Calculate the Net Present Value (NPV) for each of the options. Which option is preferable according to this technique? Explain your reasoning.
  • Calculate the internal rate of return (IRR) of the two options. Interpret your results.
  • Write a brief report (of about 150 words) for the Tolkien Transport management team advising the company on which option it should choose. Give reasons for your decision and identify any limitations of the methods applied.

Question 7

 

 

A year or so ago Tom Tolkien invested in Drive Equip Plc, a new electric vehicle equipment company, which at the time had just been listed on the UK’s Alternative Investment Market (AIM). After extensive research and development Drive Equip has just introduced an innovative navigation system which identifies the availability of electric vehicle charging points. The main distribution channel for the new product will be sales through specialist vehicle equipment distributors. However, the firm is also considering distributing the system using direct marketing.

The distribution and promotional costs differ, so the profitability of the product varies with the method selected. Using specialist vehicle distributors, the profit contribution per unit amounts to £120; if the company uses direct marketing the profit contribution rises to £160 per unit. In addition, the company’s estimate of the advertising costs and sales time per unit sold will also vary with different distribution channels. The relevant information is summarised in the table, below.

Specialist Distributor Direct Marketing
Advertising cost per unit £24 £36
Sales time per unit sold 5 hours 6 hours

Drive Equip management has specified that at least 1100 units must be distributed through direct marketing during the first three months. The company has set its advertising budget at £96,000 and has stated that a maximum of 24,000 hours of sales time will be available for the three-month planning period. In addition, production capacity for this period is 3000 units.

  • Formulate as a linear programming problem, where the aim is to determine the most profitable distribution strategy.
  • Solve the problem graphically and confirm algebraically, indicating the number of units that should be sold through each distribution channel (specialist distributors and direct marketing), and the maximum achievable profit contribution.
  • Explain precisely what is meant by the shadow price or dual value of a constraint, illustrating your answer with data from the Excel Sensitivity Report for the problem, which is provided below.
  • Using the Excel Sensitivity Report, identify the range of values for the profit contribution of the two distribution channels for which the optimal solution identified in (question 2 ) remains valid.

 

 

 

[Excel Sensitivity Report and Present Value Table are on the next page]

 

 

 

 
 

 

 

 

 

 

 

 

 

 

 

Present Value of £1

Microsoft Excel 16.0 Sensitivity Report

 

 
Variable Cells
      Objective Allowable Allowable
  Cell Name   Coefficient Increase Decrease
  $D$5 Q produced Specialist Distributor 120 40 13.3
$E$5 Q produced Direct Marketing 160 20 40
Constraints
    Shadow Constraint Allowable Allowable
  Cell Name Price R.H. Side Increase Decrease
  $C$10 Direct Marketing amount Amount used 0 1100 900 Infinity
$C$11 Production amount Amount used 40 3000 450 333.3
$C$8 Advertising Budget Amount used 3.33 96000 12000 10800
$C$9 Sales Time Amount used 0 24000 Infinity 7000
           

 

 

         
Present Value of £1
     
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
(after n years)
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486
21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.2415 0.1987 0.1637 0.1351

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