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 Ng’s
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 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. The Teng 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. Assuming Draw a decision tree to represent the decision problem in the case. Write down the
appropriate probabilities and monetary values.

Design of the decision tree

F Develop 624-350-150-80
A Not Purchase
43 E Add fees 44
=44

p=0.5
D Approved
848
=16000*3500*7.8

P =0.6 G Do Not Develop -350-80=6.8

44m

44 H Develop 16000*5000*5.5-
350mn=124
C No fees 124

Apply for I p=0.5

permission
J Do Not Develop
16000*3500*7.8-

350= 86.8
L Develop
(42)

44
K Rejected (16)

B Purchase P=0.4

M Do Not Develop
(16)

O Develop (42)

(16)
N Do Not
Apply (16)
P 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 it’s 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 government approves 60% of the applications for an increase in
development ratio. Within what range should this percentage lie so that your decision strategy
from 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 the Government approves for higher development ratio and impose additional 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 & (1-
p) 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 say-

p×(44*0.5+124*0.5)+(1-p)(-16) ≥ 43

 84p+16p ≥ 43+16
 p ≥ 0.59

So the range for p should be 0.59 ≤ p ≤1 (59% to 100%)

4. Mr. Ng feels that there is a 50% chance that the government will charge an additional fee when it
approves an application for an increase in development ratio. Within what range should this
percentage lie so that your decision strategy from 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 government will or will
not approve Mr. Ng's application for development ratio increase, what is the information 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 Ng’s 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 unchanged and if the government approves the 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 value with perfect information will 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 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 consultant is known to be 80% accurate in his
predictions?

Design of the decision tree

D Do not Apply (16)

C Buy 64 F Consultant Correct 0.8 84

64
A Approve p=2/3
E Apply 64

H Do Not Buy
43

G Consultant incorrect 0.2 (16)

57

I Do Not Buy
43

43
B Reject (1-p) =1/3 K Do not Apply (16)

M Consultant Correct 0.2 84

J Buy 4

L Apply 4

N Consultant incorrect 0.8(16)

*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 (Government’s 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 Lo’s
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 Development Ratio of 5.5 Development Ratio of Development Ratio of 7.8,
parameters determinig 7.8, additional cost of 80 no additional cost
mn
 decision to purchase and Develope Undevelope Develope Undevelope
Developed Undeveloped
develop d d d d
Price of Purchase of Property 350 350 350 350 350 350
Additional Cost imposed by
Govt. 0 0 80 80 0 0
Average Selling Price per sqft 5000 3500 5000 3500 5000 3500
Cost of development 106 0 150 0 150 0
Expected Selling Price 440 308 624 436.8 624 436.8
Net Profit -16 -42 124 86.8 124 86.8
Opportunity loss (Bank
Interest) 54.72 42 69.6 51.6 60 42

Comparative gains table assuming Price of Property=300 mn

Development Ratio of
Development Ratios v\s Development Ratio of 7.8,
Development Ratio of 5.5 7.8, additional cost of 80
parameters determinig no additional cost
mn
decision to purchase and Develope Undevelope Develope Undevelope
Developed Undeveloped
develop d d d d
Price of Purchase of Property 300 300 300 300 300 300
Additional Cost imposed by
Govt. 0 0 80 80 0 0
Average Selling Price per sqft 5000 3500 5000 3500 5000 3500
Cost of development 106 0 150 0 150 0
Expected Selling Price 440 308 624 436.8 624 436.8
Net Profit 34 8 174 136.8 174 136.8
Opportunity loss (Bank
Interest) 48.72 36 63.6 45.6 54 36

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.