Question

A kitchen appliance manufacturer is deciding whether or not to in- troduce 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 loose $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

a)

Payoff for each alternative and particular demand regime is calculated by subtracting the cost of each alternative from the income

Resulting payoff table is following:

	High demand	Medium demand	Low demand
Expansion	14000000	8750000	250000
New Construction	39000000	8750000	-750000
Don't Introduce	-10500000	-1500000	0
Probability	0.1	0.3	0.6

Decision tree is following:

Using Expected Value approach,

Expected Value of Expansion = 0.1*14000000+0.3*8750000+0.6*250000 = $ 4,175,000

Expected Value of New Construction = 0.1*39000000+0.3*8750000+0.6*-750000 = $ 6,075,000

Expected Value of Expansion = 0.1*-10500000+0.3*-1500000+0.6*0 = $ -1,500,000

Expected Value of New Construction is the highest ( $ 6,075,000)

Therefore, the company should Build a new facility (New Construction)

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b)

If the company finds itself in a difficult financial situation, then it should reconsider the decision of New construction, because it requires higher investment and higher risk. So, company should adopt a conservative approach, which maximizes the minimum payoff. Minimum payoff of Expansion is $ 250,000, which is the highest of the minimum payoffs of all the alternatives,

In that situation, the best decision is to renovate the existing facility (Expansion)

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c)

We need to determine the Expected Value of Perfect Information (EVPI)

Expected Value with Perfect Information, EVwPI = SUMPRODUCT of probability of each demand regime and Maximum payoff for that demand regime

= 0.1*39000000+0.3*8750000+0.6*250000

= $ 6,675,000

EVPI = EVwPI - EVmax (EVmax is computed in part 1, i.e. EV of new construction)

= 6675000 - 6075000

= $ 600,000

EVPI is positive, which means, thorough market research study should be performed, if it can provide perfect information. But the cost of such market research study should NOT exceed EVPI, i.e. $ 600,000

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d)

Severe financial constraints could warrant a delay in expansion plans. Furthermore, visibility about prevailing demand regime could also warrant expansion after year 1. If the demand is high in year 1, then the probability of high demand and profit would increase with expansion after year 1

.

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