Question

The Vita Plastics Assembly Company (VPAC), which has its headquarters in St Louis, Missouri, is considering opening a manufacturing plant in an overseas country and transferring much of its current US-based production to the new plant. After extensive data collection and visits by managers to a number of possible countries Almeria has been identified as the most promising country for a new plant. A site near the capital, Lasia, appears to be highly suitable and a new state-of-the art manufacturing facility could be constructed there very quickly.

The decision on whether to go ahead with the move to Almeria will be based on the level of monetary savings in production costs that it is hoped would be generated over the next 10 years by opening a plant there. However, there are a number of risks associated with these savings and, for simplicity, the level of savings has categorized as either high, medium or low. If a move to Almeria does go ahead, VPAC will review the success of its investment after the first five years and will have the option of withdrawing from that country and returning operations to the USA if this appears to be appropriate.

Almeria has a relatively new democracy which was created following the overthrow of a military dictatorship that had ruled the country for nearly thirty years. However, there is considerable poverty and unemployment rates have recently been as high as 38%. The current government is therefore keen to attract foreign investors, but it only has a narrow majority in the country’s parliament. Despite the efforts of the government widespread corruption has persisted and Almeria is ranked 5th in the World league table of corruption. Corruption is partly responsible for the neglect of the country’s road and rail systems which are now amongst the worst in the region.

If a decision is made to relocate to Almeria there is a risk that a new government will come into power and nationalize all foreign investments. There is thought to be only a 0.05 probability of this happening during the first five years, but if it did occur, the loss of assets would cause VPAC to be worse off by $75 million (in present value

terms) compared to the returns that would have been generated by continuing manufacturing in the US. Nationalization would also cause VPAC’s association with the country to end immediately. There is also an estimated 0.3 probability that within the next five years, restrictions will be imposed by the government on the convertibility of local currency into foreign currency.                                  This would reduce savings by an estimated $43 million (nationalization and currency restrictions can be assumed to be mutually exclusive events).

Insurance can be purchased to cover both of these political risks for the first five years of operations by paying a total premium which has a present value of $16 million. (Note that the insurance can only be purchased at the start of the five years).If the company does purchase political risk insurance and nationalization occurs in the first five years then the insurance will only cover the loss of assets. It is expected that any savings generated before nationalization would be canceled out by the costs of relocation and so would have present value of $0. If nationalization does not take place it is thought that there is a 0.6 probability that in the first five years the investment would generate high savings having an estimated present value of $85 million. There is also an estimated 0.25 probability that medium savings, with a present value $48 million, would be earned in the first five years and a 0.15 probability these savings will be low and only amount to $5 million. If no political insurance has been purchased currency restrictions would reduce these savings by the estimated amount given above

At the end of the first five years the company would have to decide whether to continue to operate the plant in Almeria for another five years or whether to transfer operations back to the US. However, this decision will only be considered if the savings in the first five years have been low. If a decision to withdraw is made then the plant will be sold for a return with an estimated present value of £10 million. If VPAC decide to continue operations in Almeria for a further five years the risk of nationalization during this period is difficult to estimate but is thought to be between

0.1 and 0.2. However, the risk of restrictions on the convertibility of local currency is estimated to be the same as that in the first five years. The total insurance premium

to cover these risks for the second five years would have a present value of $12.8 million. If insurance is purchased and nationalization occurs in the second five years then it is the assumed that gross savings made before nationalization will again be cancelled out by the costs arising from the disruption. For simplicity, the present values of other costs and savings occurring under each set of conditions in the second five years are assumed to be the same as those in the first 5 years, with a 20% reduction to take into account the time value of money. However, it is thought that the probabilities of high, medium and low returns in the second five year period will be dependent on the level of returns achieved in the first five years as shown in the table below.

Second five years

		High	Medium	Low
	High	0.60	0.30	0.10
First five years	Medium	0.10	0.80	0.10
	Low	0.03	0.07	0.90

For example, the table shows, that if savings in the first five years have been high then there is a 0.60 probability that high savings will be maintained in the next five years, a 0.3 probability that only medium savings will be generated and a 0.10 probability that savings will be low. The other two rows can be interpreted in a similar manner. It can be assumed that, if the company stays in Almeria, for ten years it will sell the plant at the end of this period and hence generate extra returns with a present value of £6 million

Question 1

Analyse the decision problem faced by VPAC and recommend the policy that the company should pursue.

Question 2

Discuss the strengths and limitations of your model in terms of the usefulness of the guidance that it would provide to VPAC’s managers.

Answer 1

1. VPAC should understand the entire issue and should plan to shift to Almeria even if there is a slight risk in it. It will help the company to produce and manufacture their products at a lower risk. Also, there is a probability of risk which can be covered through insurance by the organization and as the probability ratio is high in savings, it is right for the VPAC managers to shift to Almeria. The policy should also be made that the costs incurred in the first five years should be low for the organizations and the savings made by the company should be high for the first five years.
2. The strength that this model has is that the costs the organization incurs will be very low as the manufacturing costs will be very low for the organization. The other positive of this plan is that even if there are risks they will be insured by the companies. The limitations of this model are that it will increase the risks for the organizations, will lead to low savings for the company, and also can lead to total bankruptcy for the organization.