7. A chemical manufacturer is setting up capacity in Europe and North America fo

Question

7. A chemical manufacturer is setting up capacity in Europe and North America for the next three years. Annual demand in each market is 2 million kilograms (kg) and is likely to stay at that level. The two choices under consideration are building 4 million units of capacity in North America or building 2 million units of capacity in each of the two loca-tions. Building two plants will incur an additional one-time cost of $2 million. The variable cost of production in North America (for either a large or a small plant) is currently $10/kg, whereas the cost in Europe is 9 euro/kg. The cur-rent exchange rate is 1 euro for U.S. $1.33. Over each of the next three years, the dollar is expected to strengthen by 10 percent, with a probability of 0.5, or weaken by 5 per-cent, with a probability of 0.5. Assume a discount factor of 10 percent. What should the chemical manufacturer do? At what initial cost differential from building the two plants will the chemical manufacturer be indifferent between the two options?

Explanation / Answer

Region Europe N. America (in millions) Demand 2 2 4 10.88182 Capacity i 0 4 ii 2 2 Var cost 9euro 10$ NPV I year Prob NPV II year I year 11.97 10 (in dollars) 11.97 10 Strong 13.167 10 11.97 10 0.5 10.88182 Weak 10.773 10 9.793636 10 0.5 8.903306 Additional cost of building plant 2 Difference in Var cost I year Prob Exp diff II Year III year At par 1.97 Strong 3.167 0.5 1.5835 1.97 0.5 0.985 0.882 0.5 0.441 Weak 0.773 0.5 0.3865 -0.201 0.5 -0.1005 1.097 0.5 0.5485 1.97 0.8845 0.9895 Expected value of difference in 3 years after adjusting with npv 3.844 As expected value is different i.e. more in Europe, wise to invest in North America, when other demand factors are the same. At any initial cost, Europe is more costly than North America. Hence only to invest in North America

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