Question

Expando, Inc., is considering the possibility of building an additional factory that would produce a new addition to their product line. The company is currently considering two options. The first is a small facility that it could build at a cost of $6 million. If demand for new products is low, the company expects to receive $10 million in discounted revenues (present value of future revenues) with the small facility. On the other hand, if demand is high, it expects $13 million in discounted revenues using the small facility. The second option is to build a large factory at a cost of $10 million. Were demand to be low, the company would expect $11 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $15 million. In either case, the probability of demand being high is 0.60, and the probability of it being low is 0.40. Not constructing a new factory would result in no additional revenue being generated because the current factories cannot produce these new products.

a. Calculate the NPV for the following: (Leave no cells blank - be certain to enter "0" wherever required. Enter your answers in millions rounded to 1 decimal place.)

Plans	NPV
Small facility	$.........	million
Do nothing	..........	million
Large facility	..........	million

b. The best decision to help Expando is  

A-	to build the large facility.
B-	to build the small facility.
C-	to do nothing.

Answer 1

_Solution:-

_{a) i)} Calculation of NPV for small facility

                              Cost of building facility=$6 million

                              PV of cash flow if demand is low=$10 million

                              PV of cash flow if demand is high=$13 million

                              Probability of demand being high=0.60

                              Probability of demand being low=0.40

Now,

      PV of expected inflows form project

                              =$10 million*0.40+$13 million*0.60

                              =$11.80 million

NPV of the small facility =PV of inflows-PV of outflows

                                      =$11.80 million-$6 million

                                      =$5.80 million

ii) NPV if nothing is done=0 since there is no cash outflow as well as no cash inflow.

iii) calculation of NPV of the large facility.

                              Cost of building facility=$10 million

                              PV of cash flow if demand is low=$11 million

                              PV of cash flow if demand is high=$15 million

                              Probability of demand being high=0.60

                              Probability of demand being low=0.40

Now,

      PV of expected inflows from large facility

                              =$11 million*0.40+$15 million*0.60

                              =$13.40 million

NPV of the large facility =PV of inflows-PV of outflows

                                      =$13.40 million-$10 million

                                      =$3.40 million

b) The best decision to help expando is

                              -to build small facility .

Note:- Because the NPV of the small facility is greater than the other two options.