Managerial Decision Making in Balfour Wimpey Builders

AS and A Level Business Studies

MANAGERIAL DECISION MAKING

TABLE OF CONTENTS

PAGE

Part 1 2

Part 2 4

Sources of Data 6

APPENDICES (at the end)

APPENDICES A -Option 1 decision Three

APPENDICES B- Option 2 Decision Three

APPENDICES C- Option 3 Decision Three

Part 1

The traditional neo-classical model of the firm assumes that all firms regardless of their size have one sole objective, to maximise profit. Since the creation of this theory many new theories have come out trying to shed light on how firms behave. These latter theories consider the firms as complex organisations, with having more variety in their decisions, that the separation of owners (shareholder) from the decision maker (managers) can cause the firm to behave differently i.e. not only to maximise profits.

Balfour Wimpey Builders (BWB) is a medium sized firm with a management team of 5 people and 200 of other personnel. Assuming it is very likely that it will have some regional market power, BWB is an ideal firm for many firm behaviour theories. In this assignment BWB will also be assumed to have a “U” form management structure, which can be imagined to suit its size and the nature of its business best.

Neo-classical model has been challenged many of newer theories which came out during the 1950s and 1960s. These different theories put forward the idea that as long as the firm is not run by its owner, that is as long as there is an agent-principal relationship, the manager will always have conflict in interest with the owner; this problem is called the principle agent problem. This agency problem can result in the managers making decision which will not satisfy and contradict with the demands of the principles.

The owners (shareholders) of most companies see the best solution to this problem is to give substantial amount of ownership of the company to the managers. This is done so that the agency problem can be minimised by setting the aims of the managers in the same line with the goal of the stakeholders, the goal for the shareholder (which now managers become a part off) is to maximise profits (MDM Course Handbook, P19). But to what extent does this strategy work? Does it effectiveness vary depending on the type of business, the level of competition, threats of takeover, or any other internal or external factors? The latter part of this essay will examine this.

In principal-agent relationship, even when the manager owns some of the company, there will always be an agent-principle problem to some degree i.e. the problem of agent-principle can never be solved 100%. This is because the managements could always find themselves in situations where the gain of taking advantage of the situation would have a greater personal pay-off compared to taking profit maximising path and earning extra dividends, even if the consequences of participation in that situation will result in lower dividends for every shareholder. The temptations of this sort will sometimes will be too great for the managers ...

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BWB is 30% owned by the management, 30% owned by other staff % and 40% owned by outside people (some of which is the local bank). The local bank is quiet familiar with the construction company as the bank helped to finance the company when it needed expansion. All firms are likely to go through bad times, when the company is not doing so well, losing the value of its shares and having difficult making profits. In these times the firms are likely to face a threat of takeover, especially when a substantial amount of its shares are owned by another company or a bank. Since BWB currently having difficulty staying profitable, it is in a vulnerable situation for a take over bid.

In the case of BWB the local bank is the most likely candidate to make a bid for the company. The 200 workers of BWB who own 30% of the company are more likely to sell their shares at this time when the company is not performing so good, they would want to get rid of the shares as its not giving out much dividends, and also take advantage of the rising prices of shares which is the consequence of the take over battle, selling the shares would not affect their future position in the bid. The bank would need to collect more that 50% of the company shares in order to succeed in its bid. A successful bid would be a financial and humiliating disaster and for the company managers, who are very likely to lose their jobs after a takeover.

Even thought the managers have a substantial ownership of the firm, in this situation the managers would take decisions about the firm that would improve their job security rather than to try and maximise their profits. In this case they would behave in accordance to the Behaviour models (Simon 1959/Cyert & March, 1963, P21). These behaviour models argue that firms are complex organisations that do not have one definitive goal, instead the stakeholders of the organisation have goals, and if there is more than one stakeholder then there are multiple goals in the organisation. This means that the organisations goal is not to maximise anything, but rather to satisfy and achieve satisfactory levels in different goals “Satisficing”. In the case of BWB to deter the threat of a bid the managers would want to maximise the growth (Marris, 1964 P20) or sales of the firm in order to keep the value of the shares high.

Depending on the market power of the firm, the company might want to expand the volume of its sales, and grow in size, which might be in line with their long-term goal of higher profits, therefore even thought they may want higher profits in the long run, short run strategy will be concentrated on growth and sales volume and valuation ration (to attract finance & raise funds, money lenders usually looks at sales volumes and share value), the firm might also have to change its location in the short run for many different reasons therefore profit maximisation might have to be sacrificed.

These theories were made in the 1950s and 1960’s and are considered old fashioned and out of date, the firms nowadays might be facing different environments or managers might have different gains from different places. The firm are now also facing much fierce competition due to globalisation therefore they might need other strategies in order to survive i.e building niche market.

Part 2

Balfour Wimpey Builders have three options that they need to choose between, where each one of them are mutually exclusive (they cannot only chose one of them), this part of the assignment will try and help BWB make up their decision on what they should do and also advise them on what other information if any they need (both quantitative and qualitative) in order to make the best decision.

The characteristics of the decisions made by the company a long term strategic decisions, Option 1 is highly risky in it nature because you have a chance to make a loss, but the chances for making high profits are also high (ideal for risk lovers and risk neutral people).

Because the options are ‘mutually exclusive, a simultaneous decision tree assessment is not an option . Sequential decision tree can also be considered as the firm only has limited time and resources for one.

After drawing the decision three (which can be found in the appendices), the following results have been obtained for the Expected value of each decision. The highlighted letter for each option is the optimal expected value of each option.

After observing the table and the decision trees following have been found

Option 1 gives the biggest EMV £1,742,500 compared to option 2 £1,572,000 and option 3 £1,178,500 therefore it is advisable for the firm to take that decision (But it is also risky), also when making the decision whether to compete for sub contract or to cut prices before building any houses it seems that sub contracts £1,742,500 are the best option compared to building houses £1,390,000.
Option 3 is the least desirable choice as it gives the least amount of payout and when looking at the different possible outcomes from option 3 compared to option 2 Option 2 is always comes out at the top (no risks of any loss or no gain in both of them. Therefore if there was a choice between option 1 and option 2 its must be the definite choice
Even though The EMV of option 1 is greater that the EMV of option 2 there is not much percentage difference between the expected values of the two (9.78%), therefore I will use sensitivity analysis to determine which will be the best choice.

Assumptions about BWB;

The company is a midpoint between maximin and minimax, it wants to avoid risks if that risk is too high and the opportunity loss is low.
The firm is a profit maximizer. The main objective of the firm is to make as high profits as possible.
The investment of £500K made by the firm in the second year of option 1 will have further long term benefits therefore will not affect decision making..

Risk analysis for option 1

In option 1 there is same riskiness for both cutting houses and subcontracting therefore the firm should chose subcontracting because it has the highest EMV. In option 1 the highest probability in year 1 after choosing sub contracting is a profit of £750,000 and there is not much oscillation between other probabilities (N&O) therefore year 1 is not risky, however subcontracting gets risky in year 2 and 3, in these years there is 25% chance of making a loss of £900,000 which is a huge amount, and very undesirable since this chance continues for year 3 as well than the probability of making a loss in one of them becomes.

The probability of the firm making a profit of £1,000,000 in both year 2 and year 3 is (0.75*0.75=0.5625) therefore the chances of a loss making year happening in any one of years 2 or 3 is 1-0.5625=0.4375, this is a big probability and a risk aversive firm would avoid this scenario at all cost. Therefore it seems that option 1 is undesirable compared to option 2 (0.5625%)

Sensitivity Analysis of option 1;

Sensitivity analysis addresses the basic question, how should the decision maker alter his or her decisions in the light of uncertain outcomes

For the sensitivity analysis I am going to use the Laplace (equal likelihood) criterion to work out the average payoff of Option 2 at the end of year 3 (because there is not much percentage deference between each outcome).

Laplace criterion for option 2:- 1.8+1.35+1.5+1.05+1.65+1.2+1.35+0.9=1.138

Therefore £1138000 million is the average payoff of option 2 using Laplace criterion. Now I can use this value to help me carry out a sensitivity analysis for Option 1, subcontract, probability node K (this is the risky part of Option 1)-“see appendices A”. I am using K because it is the most likely outcome and the Average.

I have done a sensitivity analysis on probability node K of option 2. The sensitivity looks at the probability that node K will pay of a profit of £388000 (the amount required to at least gain a payoff which is overage of the outcomes of option 2). The analysis shows that it is more likely to have profit less than £388000 (60%), this analysis shows that Option 2 is more suitable for a risk averse decision making firm like BWB. SEE DIAGRAM

Additional Information the company needs

The firm needs to be profitable in the next 9 months in order to stay alive. Therefore the company needs the amount of credit that needs to be give back, this information will tell show them the amount of profit they need to have in the short run (first year), therefore they can reassess which options the would consider. (if the credit is very high then option 1 might be more desirable then option 2). This is a quantitative data

How did the managing director asses the probabilities of each option? If the assessments were subjective then the company might need more objective research in order to find the accuracy of the assessments. This is both qualitative and quantitative data

They might also need information on their local bank, and the risks they are facing from a bid to take over, this is a qualitative data, see part 1 for more details.