Kowloon Development Co. Ltd.

Assumptions

All decisions (dev. ratio increase; charging

additional cost) are instantaneous and
happen on the first day.

All payoffs are realized after two years.

2
Outcomes
Put money in bank
Buy property, do not apply for development ratio increase
Do not construct
Construct
Buy property, apply for development ratio increase
Application does not go through
Do not construct
Construct
Application goes through
Additional cost charged
Do not construct
Construct
No additional cost charged
Do not construct
Construct

3
 Cost Calculations
Property Size 16000sq. ft
Selling Price per Sq. Ft. 5000HKD/sq. ft Build
3500HKD/sq. ft Otherwise

Government levies Additional cost No additional cost

Development ratio 5.5 5.5 7.8 7.8 7.8 7.8
Dont Dont
Decision Construct construct Construct construct Construct Dont construct
Cost price (million HKD) 350 350 350 350 350 350
Construction Cost
(million HKD) 106 150 150
Additional Cost (million
HKD) 80 80
Total Costs (million
HKD) 456 350 580 430 500 350
Selling Price (million
HKD) 440 308 624 437 624 437
Nett Gain (million HKD) -16 -42 44 7 124 87
4
 Cost Calculations
Dev ratio 5.5 Dev ratio 7.8; Dev ratio 7.8;
Added cost No added cost
Construct Dont Construct Dont Construct Dont
Construct Construct Construct
Selling price 440 308 624 437 624 437

Purchase 350 350 350 350 350 350

price
Addnl. cost 80 80

Construct cost 106 150 150

Total cost 456 350 580 430 500 350

Nett (16) (42) 44 7 124 87

5
But this analysis is
WRONG!

6
 Cost Calculations
Dev ratio 5.5 Dev ratio 7.8; Dev ratio 7.8;
Added cost No added cost
Construct Dont Construct Dont Construct Dont
Construct Construct Construct
Selling price 440 308 624 437 624 437
Purchase price 350 350 350 350 350 350

Addnl. cost 80 80

Construct cost 106 150 150

Total cost 456 350 580 430 500 350

Nett (16) (42) 44 7 124 87

Kowloon has to put aside $580M

7
 Cost Calculations
Dev ratio 5.5 Dev ratio 7.8; Dev ratio 7.8;
Added cost No added cost
Construct Dont Construct Dont Construct Dont
Construct Construct Construct
Selling price 440 308 624 437 624 437

Purchase price 350 350 350 350 350 350

Addnl. cost 80 80

Construct cost 106 150 150

Total cost 456 350 580 430 500 350

Unused funds 124 230 0 150 80 230

Interest 15 28 0 18 10 28

Nett (1) (14) 44 25 134 115

8
Bank interest (on $580M) = $71.7M
Outcomes
Put money in bank
Buy property, do not apply for development ratio increase
Do not construct
Construct
Buy property, apply for development ratio increase
Application does not go through
Do not construct
Construct
Application goes through
Additional cost charged
Do not construct
Construct
No additional cost charged
Do not construct
Construct 9
Outcomes
Put money in bank HKD 71.7 Million
Buy property, do not apply for development ratio increase (HKD 1 Million)
Buy property, apply for development ratio increase
Application does not go through (HKD 1 Million)
Application goes through
Additional cost charged HKD 44 Million
No additional cost charged HKD 134 Million

10
Outcomes
Put money in bank HKD 71.7 Million
Buy property, do not apply for development ratio increase (HKD 1 Million)
Buy property, apply for development ratio increase
Application does not go through (HKD 1 Million)
Application goes through
Additional cost charged HKD 44 Million
No additional cost charged HKD 134 Million

11
Decision Tree
$71.7M
Put money
in bank
Addnl. fee
charged
$44M
p = 0.5
Accepted

Buy property, p = 0.6 Addnl. fee

not charged
apply for d.r. $134M
increase p = 0.5
Rejected
($1M)
p = 0.4

12
Decision Tree
$71.7M
Put money
in bank

Accepted
Buy property, $89M
apply for d.r. p = 0.6
increase

Rejected
($1M)
p = 0.4

13
Decision Tree
$71.7M
Put money
in bank

Buy property,
apply for d.r.
increase
$53M

14
 Question

If a consultant could inform Ng about whether

the government would approve the
application, how much should Ng be willing to
pay for this information? Assume that the
information that he receives is fully reliable.

15
Decision Tree
$71.7M
Put money
in bank
Addnl. fee
charged
$44M
p = 0.5
Accepted
Buy property,
apply for d.r. p = 0.6 Addnl. fee
not charged
increase
$134M
p = 0.5
Rejected
($14M)
p = 0.4

16
Decision Tree
$71.7M
Put money
in bank
Addnl. fee
charged
$44M
p = 0.5
Accepted
Buy property,
apply for d.r. p = 0.6 Addnl. fee
not charged
increase
$134M
p = 0.5
Rejected
($14M)
p = 0.4

17
Decision Tree
$71.7M
Put money
in bank

Ask
consultant

18
Decision Tree
$71.7M
Put money
in bank

Consultant
says yes
BUY
Ask p = 0.6
consultant
Consultant
says no
DONT BUY $71.7M

p = 0.4
19
Decision Tree
$71.7M
Put money
in bank

Addnl. fee
charged
Consultant $44M
says yes p = 0.5
BUY
Ask p = 0.6 Addnl. fee
consultant not charged
Consultant $134M
says no p = 0.5
DONT BUY $71.7M

p = 0.4
20
Decision Tree (with consultant)
$71.7M
Put money
in bank

Value of the consultation

= $82.1M - $71.7M
= $10.4M

Ask
consultant
$82.1M

21
Decision Tree (with consultant)
$71.7M
Put money
in bank

Expected Value Perfect Information

= $82.1M - $71.7M
= $10.4M

Ask
consultant
$82.1M

22
More Questions

If a consultant could inform Ng about

whether the government would approve the
application, how much should Ng be willing
to pay for this information? Assume that the
information that he receives is fully reliable.

What would Ng be willing to pay, if he knew

that the information he was receiving was
90% reliable?
23
Decision Tree (with consultant)
$71.7M
Put money
in bank

Addnl. fee
charged
Consultant $44M
says yes p = 0.5
BUY
Ask Addnl. fee
consultant not charged
Consultant $134M
says no p = 0.5
DONT BUY $71.7M

24
Decision Tree (with consultant)
$71.7M
Put money
If you are paying money to the
in bank
consultant, you WILL FOLLOW
THEIR ADVICE

Consultant is
right
Consultant $89M
says yes p = 0.9
BUY
Ask p1 Consultant is
consultant wrong
Consultant ($1M)
says no p = 0.1
DONT BUY $71.7M
1-p1

25
Finding p1
Actual Actual
Approval Rejection
Consultant
probability that probability that
says
source is right source is wrong
Approved
Consultant
probability that probability that
says
source is wrong source is right
Rejected

26
Finding p1 and p2
Actual Actual
Approval Rejection
Consultant
says 0.9p1 0.1p1 p1
Approved
Consultant
says 0.1(1-p1) 0.9(1-p1) 1-p1
Rejected

60% 40%

0.9p1 + 0.1 (1-p1) = 0.6,or

0.1p1 + 0.9 (1-p1) = 0.4 p1 = 5/8, 1-p1 = 3/8
27
Decision Tree (with consultant)
$71.7M
Put money If you are paying money to the
in bank consultant, you WILL FOLLOW
THEIR ADVICE

Consultant is
right
Consultant $89M
says yes p = 0.9
BUY
Ask p = 5/8 Consultant is
consultant wrong
Consultant ($1M)
says no p = 0.1
DONT BUY
$71.7M

p = 3/8
28
Decision Tree (with consultant)
$71.7M
Put money If you are paying money to the
in bank consultant, you WILL FOLLOW
THEIR ADVICE

Consultant
says yes
BUY
$80M
Ask p = 5/8
consultant
Consultant
says no
DONT BUY $71.7M

p = 3/8
29
Decision Tree (with consultant)
$71.7M
Put money If you are paying money to the
in bank consultant, you WILL FOLLOW
THEIR ADVICE

Value of the consultation

= $76.9M - $71.7M
= $5.2M

Ask
consultant
$76.9M

30
Decision Tree (with consultant)
$71.7M
Put money If you are paying money to the
in bank consultant, you WILL FOLLOW
THEIR ADVICE

Expected Value of Sample Information

= $76.9M - $71.7M
= $5.2M

Ask
consultant
$76.9M

31
 Value of Information

Information None 90% accurate Accurate

Payoff $71.7M $76.9M $82.1M
Value n.a. $5.2M $10.4M

NOTE: 90% of $10.4M is $9.36M

32