Question

5. After graduating from MSU, you and a couple of your friends started a house-flipping business, where you buy a house on the market, do some repairs-remodeling and resell the house within a year, hoping to make profit. Given that you are a small business, you can only work on one house project at a time. You are currently trying decide between two houses: one in East Lansing and another in Okemos, for your next buy-resell project. East Lansing houses are generally a bit older so need more work than houses in Okemos which are newer. The East Lansing house costs $500K to buy. After buying it, you can either remodel it extensively or do some minor upgrades before reselling. Extensive remodeling costs $100K and minor upgrading costs $20K. You estimate that after extensive remodeling there is an 80% chance that you will be able sell it for $700K in net proceeds (i.e. actual sale price minus the taxes, commissions, fees etc), but there is a 20% chance that the net proceeds will only be $550K. If you try to sell after just minor upgrades, there is a 50% chance that you can resell the house for $600K and 50% chance that you only get $500K. The Okemos house costs $550K to buy. After buying it, you can either add a pool and a sunroom costing $40K or simply repaint it (which costs $10K) before reselling. You estimate that after adding the pool and sunroom, there is a 60% chance that you will be able sell it for $700K in net proceeds and a 40% chance that the net proceeds will only be $500K. If you try to resell after just repainting, there is a 40% chance that you can resell the house for $600K and 60% chance that you only get $550K. Which option (which house and which upgrade option) would you choose and why? Please draw the decision tree and show all your calculations clearly.

Answer 1

CALCULATION SHOWING THE TOTAL PROFIT EARNED (HOUSE WISE)
EAST LANSING HOUSE							OKEMOS HOUSE
Particulars	Extensive remodelling (in $)			Minor remodelling (in $)			Pool & a sunroom (in $)			Repaint                        (in $)
Net proceeds (A)	700	550		600	500		700	500		600	550
Cost of buying house (B)	500	500		500	500		550	550		550	550
Additional Cost (C)	100	100		20	20		40	40		10	10
Total cost (B)+(C)=(D)	600	600		520	520		590	590		560	560
Profit (A)-(D)=(E)	100	-50		80	-20		110	-90		40	-10
Probability (F)	0.8	0.2		0.5	0.5		0.6	0.4		0.4	0.6
Probable Profit (E)*(F)=(G)	80	-10		40	-10		66	-36		16	-6
Total Profit from Project	70			30			30			10

You are suggested to buy EAST LANSING HOUSE and remodel it EXTENSIVELY as according to the above calculations it gives the highest profit of $70K, as compared to the other three models.

Decision table is attached below for your reference.

DECISION TREE HOUSING PROJECT EAST LANSING HOUSE OKEMOS HOUSE BUYING COST $500K BUYING COST $550K BUYINCOFOST EXTENSIVE REMODELLING $100K MINOR REMODELLING $20K POOL & SUNROOM $40K REPAINT $10K 80% $700K 20% $550K ba ada 50% $600K 50% $500K 60% $700K 40% $500K 40% $600K 60% $550KK Profit = $30K Profit = $10K Profit = $70K Profit = $30K HIGHEST = $70K (EAST LANSING HOUSE WITH EXTENSIVE REMODELLING)