2. A manufacturing company is considering expanding its production capacity to m

Question

2. A manufacturing company is considering expanding its production capacity to meet a growing demand for its product line of air fresheners. The alternatives are to build a new plant, expand the old plant, or do nothing. The marketing department estimates a 35% probability of a market upturn, a 40% probability of a stable market, and a 25% probability of a market downturn. Georgia Swain, the firm's capital appropriations analyst, estimates the following annual returns for these alternatives:

a. What are the decision alternatives?

b. What are the chance events?

c. What should the company do?

d. What returns will accrue to the company if your recommendation is followed?

e. What is the expected value of perfect information?

Market Upturn Stable Market Market Downturn Build new plant 690,000 -130,000 -150,000 Expand old plant 490,000 -45,000 -65,000 Do nothing 50,000 0 -20,000

Explanation / Answer

Ans: The decision alternatives are to build a new plant, expand the old plant, or do nothing.

Chance events are market scenario of upturn ,stable or downturn.

First,we will calculate the EMV for each option:

Now,Maximum EMV is given by building a new plant i.e. 152000

EVPI(expected value of perfect information)=Expected value with perfect information-Expected value without perfect information

Expected value without perfect information=Maximum EMV=152000

Now,calculate Expected value with perfect information:

choose maximum return given in each scenario , multiply by their probability and add them.

Expected value with perfect information=690000*0.35+0*0.4-20000*0.25=236500

EVPI=236500-152000=84500

Decision based on minimax regret approach:

So,the best option is to do nothing(As opportunity loss is minimum)

Market Upturn Stable Market Market Downturn EMV Build new plant 690,000 -130,000 -150,000 152000 =Maximum EMV Expand old plant 490,000 -45,000 -65,000 137250 Do nothing 50,000 0 -20,000 12500 Probability 0.35 0.40 0.25

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