Forward Software - Settlement or Else?

A Sheetal (0001/52), Aayush Goel (0005/52), Aditya Singh (0020/52),

Ajay Pratap Yadav (0026/52), Amit Ranjan (0045/52), Ankur Jain (0069/52)
Section A - Group 5
November 16, 2015

Introduction

Sam Ellis, the CEO of Forward Software which is the creator of the spreadsheet software Cinco, is worried as
Focus Software, a large competitor, has recently sued Discount Software for copyright infringement. Sam feels
that his company is the primary aim for Focus as his product is better and selling considerably more than Focus
software.
Sam, after discussing with his attorneys, has chalked out a set of possible courses of action and as is perfectly logical, would like to minimize the expected cost that his company would occur in the future. Sam is also
aware of the fact that he and his attorneys are working on estimates and he would also like to ensure that his
decision allows for some tolerance in his estimates.
Sam has also been given a proposal by an outside law firm to conduct a survey at a cost of $0.7 million to
predict the outcome of the Focus vs Discount case, since he can considerably improve his estimates and get a
more precise expected cost. However, since Sam already expects to shell out cash in the future, he has to ensure
that the survey cost is worth the information.
This report starts with a problem statement - a set of tasks that are required to solve the case and the tools
that would be utilized - which is followed by a systematic solution for each of the tasks outlined in the problem
statement.
NOTE: For the purpose of simplicity, all figures are assumed to be in millions and figures have been calculated upto two decimal places. The letter p just gives an indication that the number is a probability figure, any
variables used for formulation will be explicitly mentioned.

Problem Statement

1. To calculate minimum expected cost for the many possible courses of action identified in the case and the
uncertainty w.r.t. external factors such as decision of Focus vs Discount case and settlement amount demanded
by Focus etc.
2. To determine the recommendation to be provided to Sam Ellis i.e. what should be his decisions so that
he may achieve the optimal cost.
3. To determine whether the survey price asked for is a good price. If the answer is no, then to determine
Forwards counter offer.
4.To analyze internal/external considerations in the optimal decision scenario (i.e. without the survey) by formulating probability distributions of intermediate costs as well as optimal cost and performing One-at-a-time
sensitivity analysis of optimal cost w.r.t. various discrete probability values.
5. To analyze sensitivity of value of information to the predicted accuracy of the survey.
Tasks 1,2 and 3 would utilize the concepts of Decision Trees and Expected (Monetary) Value. Task 3 would
also utilize the concept of EVSI (Expected Value of Survey Information) and Bayes theorem to calculate revised
probabilities. Tasks 4 and 5 would involve construction of probability distribution functions and their analysis
to perform sensitivity analysis.
The final part of the report would incorporate all the analyses done into one comprehensive Final Recommendation section.
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Figure 1: Decision Tree for without survey scenario

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3.1

Case Solution
Task 1 - Without Survey Scenario Decision Tree

The decision tree for the scenario without survey is provided in Figure 1. Kindly note that some nodes and some
branches have been marked with explicit variables (probability or cost) such as p1 , p2 , x, y etc. These variables
would be utilized later on for Tasks 3-5.
In the decision tree, rectangular nodes correspond to decision nodes, oval nodes correspond to chance nodes
and rounded rectangles signify cost values as provided in the case. Each cost value includes the corresponding
attorney fees as well.
As can be determined from the decision tree, the minimum expected cost is $4.5 million. This has been determined by backward induction - working backwards to calculate the expected value at each chance node and
choosing the branch corresponding to minimum expected cost at each decision node.

3.2

Task 2 - Optimal decision strategy for without survey scenario

As there are two decision nodes in the decision tree, hence Sam Ellis must take two decisions. The 2-part decision
strategy which will enable him to reach the optimal cost is as follows 1. Sam should wait for the decision of the Focus vs Discount case. He should NOT settle right away.
2. If Focus wins the case against Discount, and THEN if Focus sues Forward, then Sam should
settle with Focus software, pay the expected cost of $12.5 million and AVOID going to trial.
If Focus loses or after winning the case against Discount, Focus does not sue Forward, then Sam Ellis need
not do anything as his cost would be 0.

Figure 2: Decision Tree for with survey scenario

3.3

Task 3 - Analysis of survey price quoted by law firm

The decision tree for the scenario with survey consideration is provided in Figure 2. This decision tree utilized
many of the expected values which have already been calculated in the decision tree of Figure 1. For the sake of
simplicity, such chance nodes have not been branched.The decision tree values also incorporate the cost of survey
which is $0.7 million.
This decision tree incorporates certain revised probabilities which have been calculated using Bayes theorem
and by utilizing the prediction accuracy of the law firm. Let F win/lose signify the event that Focus Wins/Loses
against Discount, LF Win/Lose signify that the Law Firm predicts a Win/Lose for Focus against discount. Then
the calculations for revised probabilities are as follows P (F W in) = 0.4,

P (F Lose) = 0.6

P (LF W in | F W in) = 0.9 = P (LF Lose | F W in) = 0.1

P (LF Lose | F Lose) = 0.9 = P (LF W in | F Lose) = 0.1
Using Bayes theorem,

P (F W in | LF W in) =

P (LF W in | F W in)P (F W in)

0.9 0.4
6
=
=
P (LF W in | F W in)P (F W in) + P (LF W in | F Lose)P (F Lose)
0.9 0.4 + 0.1 0.6
7

1
7
P (LF Lose | F Lose)P (F Lose)
0.9 0.6
27
P (F Lose | LF Lose) =
=
=
P (LF Lose | F Lose)P (F Lose) + P (LF Lose | F W in)P (F W in)
0.9 0.6 + 0.1 0.4
29
= P (F Lose | LF W in) =

2
29
Using Total Probability (Denominator of Bayes theorem in each of the above formulas)
= P (F W in | LF Lose) =

P (LF W in) = 0.42,

P (LF Lose) = 0.58

It can now be seen from Decision Tree 2 that if Sam Ellis were to take the survey, then his expected cost would
be $4.64 million (which is also the Expected Cost with Survey Information) which is greater then $4.5 million
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(cost for without survey case). Hence Sam Ellis should not take the survey when offered at a price of $0.7 million.
To determine Sam Ellis counter offer, let us calculate the Expected Cost of Survey Information which is
Expected Cost of Survey Information = Expected Cost without Survey Information - Expected Cost with Survey
Information assuming no charge for survey = Expected Cost without Survey Information - (Expected Cost with
Survey Information - Cost of Survey)
Here,
ECSI = 4.5 (4.64 0.7) = 0.56
Hence, Sam Ellis counter offer should be upto $0.56 million. Only in that case will the information be worth to
take the survey.
RECOMMENDATIONS: The corresponding decision strategy should be to take the survey if the survey
price is less than or equal to $0.56 million. If the survey predicts a Focus Win then Sam Ellis
should settle right the beginning instead of waiting, if the survey predicts a Focus Loss then Sam
Ellis should wait and adopt the same strategy as in the case without a survey in Task 2.
If the survey cost is still greater than $0.56 million (the law firm does not accept the counter offer), then
the decision strategy reverts back to that of Task 2.

3.4

Task 4 - Probability distributions of costs and Sensitivity analysis of optimal

decisions

It is assumed for this section that the scenario without a survey has to be taken into consideration.
The costs being considered here are marked in Decision Tree 1 as cost x and cost y, since these particular
values are linked to the decision nodes and any cost accrued to Forward can only come as a consequence of decisions taken. Note that these costs are all expected values. Probabilities considered for the analysis are marked
as p1 , p2 and p3 in Decision Tree 1. Settlement or court amount probabilities have not taken into consideration
for sensitivity analysis.
It is also to be noted that sensitivity analysis being considered here is one-at-a-time, i.e. at a time only one
probability measure is variable and the others are held constant at their normal values.
Cost y would only depend on p3 , and its value would be -

y = M in{18.9p3 + 2.5(1 p3 ) , 12.5} = M in{16.4p3 + 2.5 , 12.5}

16.4p3 + 2.5 12.5 = p3 0.609
Hence, the probability distribution of Cost y i.e. the cost at the settling/going to trial decision is 
y=

16.4p3 + 2.5
12.5

0 p3 0.609
0.609 < p3 1

The cost x can be calculated as

x = y p1 p2
Hence, the probability distribution of Cost x i.e. the cost if Sam decides to wait is 
(16.4p3 + 2.5)p1 p2 0 p3 0.609
x=
12.5p1 p2
0.609 < p3 1
and
0 p1 , p2 1
The optimal cost is x is x 8.3 and 8.3 if otherwise. Hence, consider p3 > 0.609, then x 8.3 means
that 12.5p1 p2 8.3 or p1 p2 < 0.664. If p3 0.609, then x 8.3 means that p1 p2 (16.4p3 + 2.5) 8.3 or
p1 p2 (6.56p3 + 1) 3.32. Hence the probability distribution of the optimal cost is
(16.4p3 + 2.5)p1 p2
12.5p1 p2
Optimal Cost =

8.3

0 p3 0.609 and p1 p2 (6.56p3 + 1) 3.32

0.609 < p3 1 and 0 p1 p2 0.664
otherwise
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For the optimal decision strategy defined in Task 2, it is necessary that 0.609 < p3 1 and 0 p1 p2 0.664
and then the optimal cost is equal to 12.5p1 p2 . Using the probability distribution of the optimal cost, we can
now find out the sensitivity of the optimal cost we obtained in Task 1 i.e. $4.5 million w.r.t. the parameters
p1 , p2 and p3 . The normal values of these parameters were 0.4, 0.9 and 0.9 respectively.
ONE-AT-A-TIME SENSITIVITY ANALYSIS
For the sensitivity analysis, two of the parameters will be fixed and the third one will be varied to find out
how the decision strategy elaborated in Task 2 changes. As elaborated earlier, the optimal decision strategy was
to Wait and then if Focus Won against Discount and sued Forward, the Forward was to settle.
1. p1 = 0.4 and p2 = 0.9, p3 is variable.
The decision strategy of Task 2 will be followed only if 16.4p3 + 2.5 12.5 i.e. p3 0.609. For p3 < 0.609, the
maximum value of p1 p2 (6.56p3 + 1) is 1.79 which is pretty less than 3.32.
Hence, decision sensitivity w.r.t p3 is as follows - The decision to Wait will be followed irrespective
of value of p3 , however if Focus wins against Discount and sues Forward, then Forward should settle if
p3 0.609 at an optimal cost of $4.5 million and Go to trial if p3 < 0.609 to come to an optimal
cost of (16.4p3 + 2.5) 0.4 0.9 = 5.904p3 + 0.9
Based on the figure of 0.609 vs the actual measure of 0.9, it can be said that the original decision strategy
can tolerate some estimation errors in p3 and therefore, is not very sensitive to p3 .
2. p1 = 0.4 and p3 = 0.9, p2 is variable.
Since p3 > 0.609, hence the decision to Settle conditional on Focus Win and Focus suing forward remains
the same. The optimal cost is 12.5 0.4 p2 = 5p2 . The maximum value of such a cost is 5 which is less than 8.3,
hence the decision strategy would remain exactly the same irrespective of the value of p2 , thereby
making the decision strategy insensitive to p2 for the given values of p1 and p3 .
3. p2 = 0.9 and p3 = 0.9, p1 is variable.
Since p3 > 0.609, hence the decision to Settle conditional on Focus Win and Focus suing forward remains
the same. The optimal cost is 12.5 0.9 p1 = 11.25p1 . The decision to Wait will be followed if 11.25p1 8.3
i.e. p1 0.737. Hence, Forward should Wait if p1 0.737, otherwise they should settle with Focus
right away. If they choose to Wait, then the decision strategy remains the same as in Task 2.
Based on the figure of 0.737 vs the actual measure of 0.4, it can be said that the original decision strategy
can tolerate some estimation errors in p1 and therefore, is not very sensitive to p1 .
Note that all these analyses are conditional on the values of the other two parameters remain fixed. Based
on all the three analyses above, it can be said that the decision strategy can tolerate small estimation errors in
the chance nodes and therefore, Sam Ellis can follow the same strategy in Task 2 for small deviations
in the probability figures.

3.5

Task 5 - Sensitivity of value of information to prediction accuracy of law firm

Assuming the prediction accuracy to be a variable pa between 0 and 1, by utilizing Bayes theorem and total
probability, the Expected Cost with Survey Information and therefore the Expected Cost of Survey Information
can be calculated as a function of pa . In our case, to avoid complex closed form formulas, an Excel based analysis
of ECSI vs pa has been done using Data Table and Goal Seek tools.
Using Excel, a plot of ECSI vs Prediction accuracy has been obtained (Figure 3). Focusing on the right portion
of the graph, some facts which can be obtained are as follows 1. ECSI > 0 for pa 0.8085 which is 10% lesser than the normal prediction accuracy of 0.9
= 6.16 which implies that a 5% change in predic2. Around the normal prediction accuracy of 0.9, ECSI
pa
tion accuracy should lead to an approximate change in appropriate survey fees by $0.3 million which is quite a
large amount.

Figure 3: Plot of ECSI vs Prediction Accuracy

3. Corresponding to an ECSI of $0.7 million, the corresponding required prediction accuracy is pa = 0.923
Based on facts 1 and 2, it can be therefore said that the value of the survey information is highly sensitive
to the prediction accuracy. Even a small change in the prediction accuracy may make the decision to take
the survey suboptimal. Hence, it is recommended that Sam Ellis try to ascertain that the 90% prediction accuracy figure is correct (or accurate) or not, and then only propose the counter offer of $0.56 million for the survey.
From fact 3, it is recommended that if the law firm does not accept the counter offer of Sam Ellis and if
Sam Ellis can ascertain through some other sources with certainty that the firms prediction accuracy is greater
than 0.923, then it would be optimal for Forward to accept the law firms offer of $0.7 million.

Final Recommendations

Based on the Decision Tree analysis (with and without survey) and the sensitivity analyses performed w.r.t.
probability measures and prediction accuracy, the final decision tree summary is as follows 1. If possible Sam Ellis should first try to ascertain the correct prediction accuracy of the law firm through
some external sources. Assuming no cost for such efforts, is the prediction accuracy of 0.9 is correct, then Sam
should reject the survey at a price of $0.7 million and provide a counter offer of less than $0.56 million. If
accepted, he should agree to have the survey done.
2. If Sam ascertains that the prediction accuracy is actually less than 0.808 he should not have the survey done
at any offer. On the other hand, if he ascertains that the prediction accuracy is actually greater than 0.923 and
the law firm is not accepting his counter offer, he should accept the offer of $0.7 million and have the survey done.
3. If the survey is not performed, his optimal decision strategy should be to Wait and then if Focus wins
against Discount and Focus sues Forward, he should settle with Focus.
4. If the survey is performed, then his optimal decision strategy should be to settle right at the beginning
if the Law Firm predicts a Focus Win against discount. If the Law firm predicts a loss, then he should adopt the
decision strategy detailed in point 3.