Problem
SOUTHERN ELECTRONICS, PART I Steve Sheffler is president, CEO, and majority stockholder of Southern Electronics, a small firm in the town of Silicon Mountain. Steve faces a major decision: Two firms, Big Red Business Machines and Banana Computer, are bidding for Southern Electronics. Steve founded Southern 15 years ago, and the company has been extremely successful in developing progressive computer components. Steve is ready to sell the company (as long as the price is right!) so that he can pursue other interests. Last month, Big Red offered Steve $5 million and 100,000 shares of Big Red stock (currently trading at $50 per share and not expected to change substantially in the future). Until yesterday, Big Red's offer sounded good to Steve, and he had planned on accepting it this week. But a lawyer from Banana Computer called last week and indicated that Banana was interested in acquiring Southern Electronics. In discussions this past week, Steve has learned that Banana is developing a new computer, codenamed EYF, that, if successful, will revolutionize the industry. Southern Electronics could play an important role in the development of the machine. In their discussions, several important points have surfaced. First, Banana has said that it believes the probability that the EYF will succeed is 0.6, and that if it does, the value of Banana's stock will increase from the current value of $30 per share. Although the future price is uncertain, Banana judges that, conditional on the EYF's success, the expected price of the stock is $50 per share. If the EYF is not successful, the price will probably decrease slightly.
Banana judges that if the EYF fails, Banana's share price will be between $20 and $30, with an expected price of $25. Yesterday Steve discussed this information with his financial analyst, who is an expert regarding the electronics industry and whose counsel Steve trusts completely. The analyst pointed out that Banana has an incentive to be very optimistic about the EYF project. "Being realistic, though," said the analyst, "the probability that the EYF succeeds is only 0.4, and if it does succeed, the expected price of the stock would be only $40 per share. On the other hand, I agree with Banana's assessment for the share price if the EYF fails." Negotiations today have proceeded to the point where Banana has made a final offer to Steve of $5 million and 150,000 shares of Banana stock. The company's representative has stated quite clearly that Banana cannot pay any more than this in a straight transaction. Furthermore, the representative claims, it is not clear why Steve will not accept the offer because it appears to them to be more valuable than the Big Red offer.
Questions
1. In terms of expected value, what is the least that Steve should accept from Banana? (This amount is called his reservation price.)
2. Steve obviously has two choices, to accept the Big Red offer or to accept the Banana offer. Create and solve an influence diagram representing Steve's decision.
3. Create and solve a complete decision tree representing Steve's decision.
4. Why is it that Steve cannot accept the Banana offer as it stands?
The response should include a reference list. Double-space, using Times New Roman 12 pnt font, one-inch margins, and APA style of writing and citations.