Question

A kitchen appliance manufacturer is deciding whether or not to introduce a new product. Management has identified three possible demand regimes, with associated projected income for the first year of operation. In addition, if the company decides to produce the new product, it can do so by using its existing facilities, which will cost it $3,500,000 in renovations; or build a new facility, which will cost $6,500,000. Expanding will allow it to make more product and so its potential sales can be higher. The following table contains a summary of management expectations:

		Demand Regime
	High	Medium	Low
Income with expansion	$17,500,000	$12,250,000	$3,750,000
Income with new construction	$45,500,000	$15,250,000	$5,750,000
Probability	0.1	0.3	0.6

The company believes that if the new product is not introduced, in the first year of operation the company will lose $10,500,000 in sales to competitors in a high demand regime, $1,500,000 in a medium demand regime, and $0 in a low demand regime.

(a) Construct a payoff table and decision tree for this problem.

(b) Using the expected value approach, what should the company do?

(c) The company finds itself in a difficult financial situation. How does this information affect your recommendation in part (b)?

(d) A consulting company claims it can perform a more thorough market research study. In your opinion, should this study be performed?

(e) The company has the option of constructing a new facility after 1 year of operation. In your opinion, which conditions would warrant an expansion after year 1?

Answer 1

Answer:

a)

payoff table:

	High	Calculation	Medium	Calculation	Low	Calculation
Expansion	$14,000,000	17,500,000 - 3,500,000	$8,750,000	12,250,000 - 3,500,000	$250,000	3,750,000 - 3,500,000
New Construction	$39,000,000	45,500,000 - 6,500,000	$8,750,000	15,250,000 - 6,500,000	-$750,000	5,750,000 - 6,500,000
Don't Introduce	-$10,500,000	0 - 10,500,000	-$1,500,000	0 - 1,500,000	$0	0 -0
Probability	0.1	-	0.3	-	0.6	-

Decision Tree:

b)

by using the Expected Value approach(EVP),

Exp. Value of Expansion

==> (0.1* $14,000,000) + (0.3* $8,750,000) + (0.6* $250,000)

Exp. Value of Expansion==>$4,175,000

Exp. Value of New Construction

==> (0.1* $39,000,000) + (0.3* $8,750,000) + (0.6* -$750,000)

Exp. Value of New Construction==>$6,075,000

Exp. Value of New Construction

==> (0.1* -$10,500,000) + (0.3* -$1,500,000) + (0.6* $0)

Exp. Value of New Construction==>-$1,500,000

Among these three expected values New Construction Exp. Value is Higher

Therefore, the company should do New Construction

c)

If the company sees itself in a tough economic condition, then it should rethink the choice of New construction, because it needs larger expenses including more eminent risk. Therefore, the company should choose a conventional approach, which maximizes the smallest payoff. The min payoff of Expansion is $250000, which is the highest of the min payoffs of all the choices, In that case, the best choice is to renovate the present buildings.

d)

lets calculate EVPI(Expected Value of Perfect Information):

EVwPI ==> (0.1* $39,000,000) + (0.3* 8,750,000) + (0.6* $250,000)

Expected Value with Perfect Information==>$6,675,000

EVPI(Expected Value of Perfect Information)

==> $6,675,000 - $6,075,000==>$600,000

Expected Value of Perfect Information==>$600,000

Expected Value of Perfect Information is positive, so we can say that a thoroughgoing market analysis research should be implemented if it can give accurate info. But the cost of so business analysis study should NOT exceed $600,000

e)

Critical economic limitations could assert a delay in extension ideas. Moreover, perceptibility regarding the current market management could also warrant an extension after year 1. If the demand is huge in year 1, then the possibility of high demand plus profit conditions would warrant an expansion after year 1.

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