Q5 A company, which manufactures compact disc, has found that demand for its product has been increasing rapidly over 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):
Course of action Demand rising Demand rising at Demand increasing
Faster current rate slowly or falling
Expand 500 400 -150
Build new plant 700 200 -300
Subcontract 200 150 -50
(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 10% chance that it will increase at a slower rate or fall. Assuming that the company’s objectives is to maximize expected net present value, determine
(i) The course of action which it should take
The answer is to Build new plant (expected NPV=$450000) how they figure the NPV I need the way
(ii) The expected value of perfect information
The answer is EVPI=$85000 how they figure EVPI I need the way
(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 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
The answer is the company should now expand existing plant (expected VPN=$390750)
(c) Discuss the limitation of the analysis you have applied above and suggest ways in which these limitations could be overcome.