Question

A company which manufactures compact discs has found that demand for its product has been increasing rapidly over the last 12 months. A decision now has to be made as to how production capacity can be expanded to meet this demand. Three alternatives are available: (i) Expand the existing plant; (ii) Build a new plant in an industrial development area; (iii) Subcontract the extra work to another manufacturer. The returns which would be generated by each alternative over the next 5 years have been estimated using three possible scenarios: (i) Demand rising at a faster rate than the current rate; (ii) Demand continuing to rise at the current rate; (iii) Demand increasing at a slower rate or falling. These estimated returns, which are expressed in terms of net present value, are shown below (net present values in $000s): Scenario Course of action Demand rising faster Demand rising at current rate Demand increasing slowly or is falling Expand 500 400 ?150 Build new plant 700 200 ?300 Subcontract 200 150 ?50 Exercises 239 (a) The company’s marketing manager estimates that there is a 60% chance that demand will rise faster than the current rate, a 30% chance that it will continue to rise at the current rate and a 10% chance that it will increase at a slower rate or fall. Assuming that the company’s objective is to maximize expected net present value, determine (i) The course of action which it should take; (ii) The expected value of perfect information. (b) Before the decision is made, the results of a long-term forecast become available. These suggest that demand will continue to rise at the present rate. Estimates of the reliability of this forecast are given below: p(forecast predicts demand increasing at current rate when actual demand will rise at a faster rate) = 0.3 p(forecast predicts demand increasing at current rate when actual demand will continue to rise at the current rate) = 0.7 p(forecast predicts demand increasing at current rate when actual demand will rise at a slower rate or fall) = 0.4 Determine whether the company should, in the light of the forecast, change from the decision you advised in (a). (c) Discuss the limitations of the analysis you have applied above and suggest ways in which these limitations could be overcome.

Answer 1