Expando, Inc., is considering the possibility of building an additional factory
ID: 342828 • Letter: E
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 $7 million. If demand for new products is low, the company expects to receive S9 million in discounted revenues (present value of future revenues) with the small facility. On the other hand, if demand is high, it expects $14 million in discounted revenues using the small facility. The second option is to build a large factory at a cost of $8 million. Were demand to be low, the company would expect $9 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $15 million. In either case, the probability of demand being high is 0.30, and the probability of it being low is 0.70. 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 "O" wherever required. Enter your answers in millions rounded to 1 decimal place.) Plans PV Small facility Do nothing Large facility 0 million 3.5 million 2.8 million b. The best decision to help Expando is to build the large facility. to do nothing. to build the small facility.Explanation / Answer
NPV for any given option will be given as :
NPV = Probability of low demand x Quantum of discounted revenue under low demand + Probability of high demand x Quantum of discounted revenue under high demand – Cost of building the facility
Or, NPV = 0.7x Quantum of discounted revenue under low demand + 0.3 x Quantum of discounted revenue under high demand – Cost of building the facility
Thus,
NPV of the small facility, $ Million = 0.7 x 9 + 0.3 x 14 – 7
= 6.3 + 4.2 – 7
= 10.5 – 7
= 3.5
NPV of the large facility , S Million = 0.7 x 9 + 0.3 x 15 – 8
= 6.3 + 4.5 – 8
= 10.8 – 8
= 2.8
Since there is no revenue as well as costs involved in “doing nothing”, NPV = 0
Since NPV is highest in case of building “Small Facility”, one must go for it.
PLAN
NPV
Small facility
$ 3.5 million
Do Nothing
0
Large facility
$2.8 million
The best decision is to help Expando is to build the small facility
PLAN
NPV
Small facility
$ 3.5 million
Do Nothing
0
Large facility
$2.8 million
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