Question

A Chemical company has to expand its production capacity to cater its growing local and international market .

it has to decide between a large plant and a small plant to be built to address the increasing demand. This is all that must be decided now. But if the company chooses to build a small plant, and then finds demand high during the initial period for two years, it has to expand its plant further. In making decisions, company executives must take account of the probabilities, costs, and returns which appear likely. On the basis of the data now available to them and assuming no important changes in the company’s situation, perform the following;

(i) Develop a decision tree analysis for the Chemical company for this potential investment;

(ii) Determine the net expected monetary value EMV (revenue – cost), and decide which alternative should the company

Table Q4-1

Alternatives	Probabilities
Large Plant (cost 3.0 million OMR)	High average demand	0٫6
	High initial demand (2 yrs), low succeeding demand (8 yrs)	0٫1
	Low average demand	0٫3
Small Plant (cost 1.3 million OMR)	High initial average demand	0٫7
	Low initial average demand	0٫3

Payoff per year (OMR/ year)

1٬179٬296 (for 10 yrs)

1٬000٬000 (first 2 yrs) 100٬000 (succeeding 8 yrs)

100٬000 (for 10 yrs)

537٬028 (first 2 yrs) -

400٬000 (for 10 yrs)

Table Q4-2 : Alternatives, Probabilities & Payoffs when building a Small plant with High initial average demand

(succeeding 8 years)

Alternatives after 2 years of having Small- Plant with high initial average demand	Probabilities
Expand (cost 2.2 million OMR)	High average demand	0٫86
	Low average demand	0٫14
Do not expand	High average demand	0٫86
	Low average demand	0٫14

Payoff per year for succeeding 8 years (OMR/ year)

700٬000

50٬000

300٬000

400٬000

Answer 1

2.

Expected value at node 2 = 0.6*(1181603*10)+0.1*(1000000*2 + 100000*8) + 0.3*(100000*10) = 7669618

Expected monetary value EMV(Large Plant) = Expected value at node 2-Cost of Large plant = 7669618-3000000 = 4669618

Expected value at node 5 = 0.86*(700000*8) + 0.14*(50000*8) = 4872000 Expected value at node 6 = 0.86*(300000*8) + 0.14*(400000*8) = 2512000

Expected value at node 4 = Max(Expected value at node 5- Expansion cost, Expected value at node 6)

= max(4872000 - 2200000,2512000) = 2672000

Expected monetary value EMV(small Plant) = Expected value at node 3-Cost of small plant = 3726465.2 - 1300000 = 2426465.2

Best alternative is Large plant as it has higher EMV than small plant

Please do like

Thanks