Managerial Communication II
Case study Report 1
When Consultants & Clients Clash Instructor Professor Shantanu Dey
Subhrajyoti Mandal 3 Reg. No 313/47
Overview Mr Anthony Ng the general manager of Kowloon Development Co. Ltd. is in a dilemma on whether to go ahead with a possible property acquisition and development or not. The property market in Hong Kong has been in turmoil due to the Asian Financial Crisis, for the past one year, with a decline of over 50% in the property market. Mr Ngs personal opinion is that the market has bottomed out and now is the time to look for fresh investment opportunities. The project in contention has a total site site area of 16000 square feet, and though attractive at first look, there are a few uncertainties niggling Mr Ng. He has to reach a decision quickly on whether to recommend this project to the board of directors or not. Mr Leng the current owner of the property had bought it at HKD 550 million and wants to sell it now at HKD 350 million. Mr Ng had appointed two independent property survey firms at a cost of 0.5 million to answer two questions vis-à-vis, what would be the selling price of the property after two years in the scenarios of the company developing and not developing the land. TheTeng Lo property had a development ratio of 5.5 and according to survey estimates Kowloon Co. could sell the property at the rate of HKD 3500/Sq foot without construction and at the rate of HKD 5000 per Sq foot with construction. Also adding to the predicament is the option of submitting an application to the government for increasing the development ratio from 5.5 to 7.8 that has 60% chance of approval but with a caveat, the caveat being a 50 % chance of extra HKD 80 million costs imposed by the authorities. Mr Ng realizes that careful analysis is needed before he takes his recommendations to the board of directors.
Questions
1.
Assum ing
Draw a decision tree to represent the decision proble m in the case. Write down the
appropriate probabilities probabilities a nd monetary values. Design of the decision tree
A
F Not Purchase 43
E
D
44
p=0.5 Approved
=16000*3500*7.8
G
84
44
No fees
I
Apply for ermission
B
Purchase
16000*5000*5.5-
Develop
350mn=124
p=0.5
L K Rejected
-350-80=6.8
124
J 44
Do Not Develop
H
C
624-350-150-80 =44
Add fees
P =0.6 44
Develop
Do Not Develop
16000*3500*7.8350= 86.8
Develop
(42)
(16)
P=0.4
M
Do Not Develop
O N Do Not Apply
Develop
(16)
(42)
(16)
P
(16) Do Not Develop
*All monetary values are in 000000 Hong Kong Dollars
2.
Based
on the decision tree suggest a decision strategy for Mr. Ng.
We can see from the decision tree that the decision can be divided into three parts: Part 1: From the decision tree we may say that the decision for purchase (keeping all other factors constant) gives a better payoff ($ 44 million) than investing the money in the bank (43 million). So he should go for purchasing the property. Part 2: He has to decide whether to apply for changing the development ratio or not. In this case from the decision tree it is clear that its always better to apply for changing the development ratio. So he should go for this decision as the payoff is better ( $ 44 million) in this case. Part 3: After buying and applying for changing the development ratio the best decision will be to develop the property as irrespective of the presence of extra fees, developing the property always gives the better returns (44 million if there are extra fees included and 124 million in the second case, where there is no extra fees).
3. Mr. Ng feels that the govern ment approves 60% of the applications for an increase in develop ment ratio. Within what range sho uld this percentage lie so that yo ur decision strategy fro m part (2) remains optimal? Here if we analyze from the decision tree, from branch no A the optimum decision to go for is to develop the property after aft er the Government approves for higher development develop ment ratio and impose additional addi tional costs costs in that case he will gain $ 44 mn, and again with the same previous conditions with no additional costs he will gain a maximum of $ 124 mn. These two branches in the decision tree carries 0.5 probability each which remains same for future calculations. Now previously we assigned a probability of 0.4 (Changing DR not approved) & 0.6 (changing DR approved), according to the perception of Mr. NG. Now we can assign probabilities p & (1p) to find out the decision from part 2 to remain optimal. Here the best payoff for the Not approved branch is -$16 mn, with assigned probability of (1-p), & the best payoff for approved branch is $ (44*0.5+124*0.5) mn, and the EMV from this node should be more than $ 43 mn to keep the strategy optimal. So we may sayp×(44*0.5+124*0.5)+(1-p)(-16) p×(44*0.5+124*0.5)+(1 -p)(-16) 43
84p+16p 43+16
p 0.59
So the range for p should shou ld be 0.59 p 1 (59% to 100%)
4.
Mr. Ng feels that there is a 50% chance that the gov ernment will charge an additional fee when it approves an application for an increase in development ratio. Within what range sho uld this percentage lie so that your decision decision strategy fr o m part (2) remains optimal? Our initial assumption was that at the node D there was a 0.5 probability of the authorities levying an additional fees and 0.5 probability of the authorities not levying any additional fees in lieu of increasing the development ratio. Now we consider that the probability of charging no additional fee at node I is q and the probability of charging additional fee at node E is 1-q. In this case the net EMV will be {124*q+44(1-q)}. We must note over here that the payoff from node K will remain the same as there has been no change to it. Considering this scenario, net EMV for decision to purchase should be greater than decision not to purchase to maintain the optimality of the strategy mentioned in question 2. {(124q + 44(1-q)) * 0.6} + {0.4 * (-16)} >= 43
48q + 20 >= 43
q >= 23/48
q >= 0.479
Therefore the range of q should be within 0.479 <= q <= 1 (47.9% to 100%)
5. Mr. Ng feels if a consultant can predict with 100% accuracy whether the govern ment will or will not approve Mr. Ng's application for develop ment ratio increase, what is the infor mation worth to Mr. Ng. in HKD? Let us consider that Mr Ng finds a consultant who can predict with 100% accuracy whether the government will or will not approve Mr Ngs application for development ratio increase. We need to find the value for perfect information in this case. We can see over here that if we keep the values of the payoffs and the probabilities probabil ities unchanged and if the government approves the decision decision (probability 0.6) of changing the development ratio the EMV becomes 84 for the branch ___ In the case of the government not giving its approval (probability 0.4) , investment in the bank will give better returns (HKD 43 million) than developing the property, so the expected expect ed value with perfect information will wi ll be [(84 * 0.6) + (0.4 * 43)] = 67.6 . And from our previous calculation the maximum EMV that can be obtained from the decision tree is the value we had previously found out (refer question 2) i.e. HKD 44 million. So keeping these two scenarios scenarios in mind we can say that the consultant should be paid at most 67.6 - 44 = 23.6 million.
6. How does your answer in part (5) change if the cons ultant is known to be 80% accurate in his predictions?
Design of the decision tree
D Do not Apply C Buy A
(16)
F Consultant Correct 0.8
64
84
64 Approve p=2/3
E Apply H
64
43
Do Not Buy
G Consultant incorrect 0.2 (16)
57
I
Do Not Buy
43
43
K Do not Apply
B Reject (1-p) =1/3
J Buy
(16)
M Consultant Correct 0.2 84
4
L Apply
4
*All monetary values are in 000000 Hong Kong Dollars
Considering the accuracy of the consultant at 80%, the probability that consultant would suggest an approval by the government can be found in the following way P (Governments approval) = 0.6 P(consultant suggests an approval)*P(application gets approved) + P(consultant suggests a rejection)*P(application gets approved) = 0.6 p*0.8 + (1-p)*0.2 = 0.6 p = 2/3 With perfect information, Ng will have the payoff of HKD 64 mn corresponding to COA of application to the government if the consultant suggests an approval by government. Otherwise Ng will have the payoff of HKD 43 mn by investing in bank. Hence, Expected value with perfect information = 64*2/3 + 43*1/3 = 57 Max EMV = 44 Hence Value of perfect information = 53-44 = HKD 13 mn
Qualitative analysis:
Till now we have taken into account analysis only on quantitative terms. But we should also consider the qualitative factors that might affect the decisions. The factors are as follows: 1. Firstly, Mr Ng was of the opinion that prices had bottomed out, but that was his personal opinion and might not have been true in actuality.
2. We considered the purchase offer from Teng Lo fixed at HKD 350 mn, but if Kowloon can conduct further negotiation & bring the purchase price further down than HKD 350 mn, then the decision of investing in the property becomes much more attractive as the opportunity loss of investing in bank goes down (interest income goes down) also the payoffs increase in the decision branches as the property cost decreases. Teng Los current loan withstanding with the bank is HKD 300 mn, so Kowloon has an option of negotiation from the 50 mn profit that Teng Lo is making. Teng Lo is desperate to meet its obligations with the bank so Kowloon has good prospects of bargaining & make their payoffs better for investing in the property.
3. Diagram
Comparative gains table assuming Price of Property=350 mn
Development Ratios v\s parameters determinig decision to purchase and develop Price of Pu rchase of Property Additional Cost i mposed by Govt. Average
Selling Price per sqft
Cost of develop m ent Expected Selling Price Net Profit Opport unity loss ( Bank Interest)
Development Ratio of 5.5
Developm ent Ratio of 7.8, additional cost of 80 mn
Development Ratio of 7.8, no additional cost
Developed
Undeveloped
Developed
Undeveloped
350
350
350
350
350
350
0 5000 106 440 -16
0 3500 0 308 -42
80 5000 150 624
80 3500 0 436.8
0 5000 150 624
0 3500 0 436.8
124
86.8
124
86.8
54.72
42
69.6
51.6
60
42
Developed
Undeveloped
Comparative gains table assuming Price of Property=300 mn Development Ratios v\s parameters determinig decision to purchase and develop Price of Purchase of Property Additional Cost i mposed by Govt. Average
Selling Price per sqft
Cost of develop ment Expected Selling Price Net Profit Opport u nity loss ( Bank Interest)
Development Ratio of 5.5
Developm ent Ratio of 7.8, additional cost of 80 m n
Development Ratio of 7.8, no additional cost
Developed
Undeveloped
Developed
Undeveloped
Developed
300
300
300
300
300
300
0 5000 106 440 34
0 3500 0 308 8
80 5000 150 624
80 3500 0 436.8
0 5000 150 624
0 3500 0 436.8
174
136.8
17 4
136.8
48.72
36
63.6
45.6
54
36
Undeveloped
For each of the investment decisions associated with each state of nature there is a different opportunity loss in the form of bank interest. In four out of twelve cases ( i.e 33.33% of the cases, assuming that not developing is an option) we see that bank investments generate substantial profits compared to property investments. So when making the final decision Mr. Ng should deliberate on the different alternatives.
