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 $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 $10 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 .40, and the probability of it being low is .60. 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

to build the small facility. to build the large facility. to do nothing.

Answer 1

The probability of demand being high = 0.40

The probability of demand being low = 0.60

Ans a)

Small facility

Cost of small facility = 6 million

Revenue if the demand is low = 10 million

Revenue if the demand is high = 12 million

NPV of small facility = Probability of low demand * Revenue if the demand is low +

Probability of high demand * Revenue if the demand is high - Cost of small facility

= 0.60 * 10 + 0.4 * 12 - 6

= 4.8 million dollars

Large facility

Cost of large facility = 9 million

Revenue if the demand is low = 10 million

Revenue if the demand is high = 14 million

NPV of large facility = Probability of low demand * Revenue if the demand is low +

Probability of high demand * Revenue if the demand is high - Cost of large facility

= 0.60 * 10 + 0.4 * 14 - 9

= 2.6 million dollars

NPV of 'do nothing' = 0 million dollars

Ans b)

The best decision to help Expando is to build the small facility as its Net present value is the highest among the alternatives.