(solution) Green Taxis – The Location Decision (Decision Tree) You have

(solution) Green Taxis – The Location Decision (Decision Tree) You have

Green Taxis ? The Location Decision (Decision Tree)

 

You have just graduated from UC Berkeley with your new undergraduate degree and have decided to ?change the world?. You?re very concerned about climate change and have therefore decided to start a ?green? taxi service in a developing country where greenhouse gas emission is on the rise due to increasing incomes and consumer preferences.

You have $100,000 that you will receive from your grandmother upon graduation (you?re her favourite grandchild and she?s so proud of you!). You must choose where to start your company. You estimate that demand will be 24,000 trips per year regardless of the location you choose.

You were also offered a job running the local pizza joint, where you will earn $80,000 per year for the first three years. If you take this path, the money from your grandmother is still yours and your ONLY option is to put it in a safe investment.

Further, assume that you are making a decision for the first three years, after which you will reassess your options and choice. So, to be clear, you?re ONLY evaluating the next three years. You?re risk-neutral and otherwise indifferent between the three options.

A summary of the relevant data:

Initial Investment

$100,000

Number of trips

24,000 per year (72,000 total)

Phuket ? High Fare

$9

Phuket ? Low Fare

$6

Hanoi Fare

$7

Cost per/trip with a electric

$2

Cost per/trip with a diesel

$2.50

Treasury Bond Interest Return

8.25%

 

HANOI, VIETNAM

Hanoi is an up-and-coming city and growing rapidly. With the focus of the government on reducing oil use and pollution, they have begun installing electric vehicle charging stations around the city, so you have a choice to go with either diesel or electric taxicabs. You?re certain, based on your vacations there, that you can charge an average of $7 per trip.

If you go with electric cars, then your average cost per trip will be lower than if you use diesel ($2 for electric vs. $2.50 for diesel). However, you must spend an additional 7.5% of your initial investment to go with electric (assume that you have to borrow the money to build it and that the 7.5% includes your interest repayments).

Unfortunately, the government sometimes likes to regulate businesses to control prices and inflation. You estimate that there?s a 15%likelihood that the government will institute price controls and that if they do, they will cap your average fare at $4.50 (you can assume that this average is what you?ll make per trip over the three years).

PHUKET, THAILAND

Phuket is another dream destination for you, since you love the beaches and are thrilled with the prospect of driving on the ?wrong side of the road?. You?re not sure exactly what you can charge as your average fare since you?ve never been and the information you can get from the Internet is all over the map in terms of prices. So, after much studying and modeling (which you thankfully learned and remembered from UGBA104), your subjective probabilities are a 80% chance that you can charge a higher fare of $9 per trip and a 20% chance you can only charge $6 per trip. In Phuket, your only choice is to use diesel taxis. You estimate that your cost per trip for your diesel taxis is the same that it will be in Hanoi at $2.50.

Unfortunately, the government is in a bit of chaos and it?s unclear which of the political parties will prevail in upcoming elections (or even maybe a coup). One of them (the ?Yellow Shirts?) is more business friendly and if they end up in control of the government, they will leave you alone and let you charge the market price (that you?ve estimated above). However, if the ?Red Shirts? win, then they will end up capping the average fare at $4 per trip. Your worst-case scenario though is that the ?No Shirts? take over, and they aren?t particularly fond of foreigners or for-profit companies. In this case, they will confiscate your business and kick you out.

You think there?s an 82% chance the ?Yellow Shirts? win, an 11% chance the ?Red Shirts? win, and a 7% chance the ?No Shirts? win. You will NOT know who wins until the day you finish your investment and it?s on that day that the government will take over (I know, lousy timing on your part but you gotta roll with the punches).

THE JOB, BERKELEY, CALIFORNIA

If you decide not to start your Green Taxi business, then you?re going to go into the pizza business and run a pizza place. While not saving the world from greenhouse gases, you will be saving a small part of it from crappy pizza and bringing joy to many people. You?ll earn$80,000 per year for the three years. In this case, you?ll just put the money from your grandmother into a safe investment that returns a total of 8.25% over the three years.

ASSUMPTIONS:

  • The initial investment is the amount you must spend to start.
  • The time value of money is built into the figures given. In other words, all the figures you compute are in today?s money regardless of the time horizon for each option.
  • Ignore exchange-rate risk, other political risks, etc.
  • Assume your living and all other expenses are identical across all three options.
  • Costs per trip include all relevant business costs.
  • Once you make your decision, you?re locked into it for three years.
  • At the end of the three years, you can sell the business in Hanoi or Phuket for $100,000.

 

Hint: It may be easier to draw each of the 3 options as a separate tree rather than as 1. It?ll be less messy that way.

Based on this set of assumptions, what do you do?

Complete a decision tree and don?t forget to answer the question!