Question

A company has three alternative solutions.

1. Do nothing

2. Rearrange an existing area

3. Build an addition to the present area

Planning horizon is 5 years. The MARR is 30%.

If alternative 1 is chosen, the estimated present worth is $0.

If alternative 2 is chosen there is a 60% chance of competition. The estimated PW is $50,000 if there is competition and $30,000 if there is no competition.

If alternative 3 is chosen there is 20% chance of competition. The estimated PW is (-)$100,000 if competition and $90,0000 if no competition.

Based on PW what should the company do? Are there any risk-related factors that could cause a different recommendation?

Answer 1

We will have to calculate the Expected Present Worth for each alternative to arrive at a decision as below:

PW (Alternative 1) = $0

PW (Alternative 2) = Probability of Competition*PW with Competition + Probability of No Competition*PW with No Competiton = 60%*50,000 + (1-60%)*30,000 = $42,000

PW (Alternative 3) = Probability of Competition*PW with Competition + Probability of No Competition*PW with No Competiton = 20%*(-100,000) + (1-20%)*90,000 = $52,000

_____

Tabular Representation (with Rank):

	Expected PW	Rank
Alternative 3	$52,000	1
Alternative 2	$42,000	2
Alternative 1	$0	3

Based on the above calculations, it can be seen that Alternative 3 should be selected by the company as it provides the highest expected PW.

_____

In the given case, the recommenation is based on the probability of competition and estimated PW with and without competition. The possible risk in this scenario could be the the possible variations in the probability of competition. Actual level of competition may differ as the project passes through different stages. This variation may affect the expected PW of different alternatives, which may affect the investment decision making process.