FiveGrains is one of the leading manufacturers of rice wines. According to FiveGrains’ recent internal consumer trend study, a new segment of customers demand a modern fruit-flavoured rice wines. While the demand is currently negligible due to nonproduction, it is expected to rise in the next several years. In particular, for the current year, they conjecture that with 50% the demand will be large (translating into a potential profit of
£4.5M), and with 50% it will be small (translating into a potential profit of £0.5M).
Although other firms are looking into producing the specialty rice wines, it is difficult for them to quickly do so as it requires building additional capacity, as most firms do not want to produce the specialty rice wines at the expense of sacrificing the traditional rice wine production. Regardless of whether there is high or low demand, FiveGrains believes that there is 70% chance that more than one competing manufacturers will eventually dive into the specialty rice-wine market. In such case, FiveGrains will only capture 20% of the demand and hence earn 20% of the potential profit. On the other hand, there is a 20% chance that only a single competitor enters, in which case they will be able to capture 50% of the demand and hence earn 50% of the potential profit. He believes that there is only 10% chance that nobody else will enter the market during the year, in which case they can capture 80% of the demand and 80% of the potential profit.
1. Decision Tree basic [35 marks]
- Draw the basic tree outlining the sequence of uncertainties.
- What is the expected profit if FiveGrains were to enter the fruit-flavoured rice wine market?
2. Weighing the Options [35 marks]
Suppose that FiveGrains can take certain pre-emptive actions (e.g., negotiating exclusivity deal or establishing marketing dominance quickly to deter entry) to ensure that no competitors will enter the fruit-flavoured rice wine market. What would be the value of such action?
- Construct a decision tree and determine the maximum amount FiveGrains is willing to pay to conduct such action.
- Suppose that the action will cost £1 What do you recommend FiveGrains to take this action? (Assume from risk-neutral decision maker’s perspectives.)
3. Risk Profile for each Decision [30 marks]
- Examine the risk profile for FiveGrains with the action with £1m, and without
- If the demand turns out to be high, what is the expected profit with and without the action?
- If the demand turns out to be low, what is the expected profit with and without the action?
If the FiveGrains cannot afford to lose money, which decision would you recommend?
- If you know with certainty that the demand will be large, what is the value of the action?