Question

ABC Company 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 $12 million in discounted revenues using the small facility. The second option is to build a large factory at a cost of $9 million. Were demand to be low, the company would expect $7 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $14 million. In either case, the probability of demand being high is 0.20 and the probability of it being low is 0.80. Not constructing a new factory would result in no addition revenue being generated because the current factories cannot produce these new products. For this analysis, use only the information provided.

a) Construct a decision tree to help ABC make the best decision.

b) Based on your analysis and using an expected value approach, which facility should be built?

c) Suppose the probability of the demand being low is uncertain at this time. Since the probability of low demand is uncertain, this would also mean the probability of demand being high is also uncertain. With everything else remaining the same as in a), what is the probability of low demand that make the two facility options equal based on the expected values.

d) Provide an interpretation of the results you found in c).

Answer 1

a) Decision tree
			if demand of curretn product will be low
	0.8		Present Value of Future revenue: $ 10 Million
Option A
( initial Cost: $6 Million)
	0.2		if demand of current product will be high
			Present Value of Future revenue : $ 12 Million
			if demand of curretn product will be low
			Present Value of Future revenue: $ 7 Million
Option A	0.8
( initial Cost: $9 Million)
	0.2
			if demand of current product will be high
			Present Value of Future revenue : $ 14 Million b. Computation of Net present value Probability Present Value Expected Presnt Value Net Present Value Option A Initial cost of Investment $6 Million $6 Million (a) Present value of Future revenue Demand will low 0.8 $10 Million $8 million Demand will High 0.2 $12 Million $2.4 Million $10.4 million (b) Net NPV $ 4.4Million (a-b) Option B Initial cost of Investment $9Million $9Million (a) Present value of Future revenue Demand will low 0.8 $7 Million $5.6 million Demand will High 0.2 $14 Million $2.4 Million $8 million (b) Net NPV $ 1 Million (a-b) Hence, Option A, will be better