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Subject Topic: Expected Value Question (Topic Closed Topic Closed) Post ReplyPost New Topic
  
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cpasam101
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Posted: 12 Jul 2012 at 21:12 | IP Logged  

Hi,

I am using Becker self-study to prepare for the BEC exam. I was hoping that
someone could help explain this question to me:

A vendor offered Wyatt Co. $25,000 compensation for losses resulting from
faulty raw materials. Alternately, a lawyer offered to represent Wyatt in a
lawsuit against the vendor for a $12,000 retainer and 50% of any award
over $35,000. Possible court awards with their associated probabilities are:

Award, Probability
$75,000, 0.6
$0, 0.4

Compared to accepting the vendor's offer, the expected value for Wyatt to
litigate the matter to verdict provides a:

a. $4,000 loss.
b. $18,200 gain.
c. $21,000 gain.
d. $38,000 gain.

Explanation
Choice "a" is correct.
Step 1:
Cost of award if Wyatt wins:
Retainer $12,000
Add: ($75,000 - $35,000) x 50% = 20,000
Total: $32,000

Cost if Wyatt loses: retainer $12,000.

Then they take the award and subtract the cost for each possibility and
multiply them by their probabilities.

The part I don't understand is why they subtract the $35,000 from the
$75,000 reward before taking the 50% of it. I understand that the deal is
that the lawyer will get 50% of any reward over $35,000, but this is saying
that the award will either be $75,000 or it will be nothing; so doesn't he get
50% of the full $75,000?
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ArcSine
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Posted: 13 Jul 2012 at 07:59 | IP Logged  

Lawyer gets 12K retainer regardless of case's outcome.

The wording of the problem---as well as the calculation in the solution---implies that the lawyer also gets half of the portion of an award that exceeds 35K, if any.

Hence if the case results in an award in the range of [0, 35k], lawyer only gets the 12K retainer.

For any awards in excess of 35K, lawyer gets half of the excess over 35K, not half of the entire award.

Putting it another way (ignoring the retainer), the first 35K of any award goes 100% to Wyatt; the rest (if any) is split 50/50 between Wyatt and lawyer.
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cpasam101
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Posted: 13 Jul 2012 at 09:58 | IP Logged  

Thanks, it's just the wording then! Have to pay attention to that!
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ArcSine
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Posted: 13 Jul 2012 at 12:00 | IP Logged  

Glad to help, and I concede the wording of the original problem is ambiguous; "50% of any award over $35,000" could certainly be interpreted the way you did originally.

The advantage of, um, having quite a few miles on my odometer, so to speak, is knowing that the real-world norm for such "percentage" deals is that the %-age only applies to the excess over a certain amount, not to the entire amount. Otherwise, e.g., Wyatt would paradoxically be better off with an award of $34,000 than an award of $36,000.

However, CPA exam prep material isn't typically read by those who have "been out there" for several years, and hence the drafters should be more careful with their wording.

Best of luck with your studies.
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