Question 2: A company has to make a decision regarding production capacity to me
ID: 353305 • Letter: Q
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Question 2: A company has to make a decision regarding production capacity to meet the growing demand and the estimated returns in $ for different alternatives are given Scenario Course of Action/Demand High demand 500 700 Medium demand Low Demand 400 Expand Build New Plant Subcontract a) The company's Marketing manager estimates that there is a 60% chance for high -150 300 -50 200 200 150 demand, 30% for medium demand and 10% for low demand. Assuming that the company's objective is to maximize expected net present value, determine the course of action it should take; b) Before the decision is made, the results of a long term forecast becomes available. These suggests 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 be high) P(forecast predicts demand increasing at current rate when actual demand will be medium) 0.7 P(forecast predicts demand increasing at current rate when actual demand will be low) 0.4 Demonstrate whether the company should, in the light of the forecast, change from the decision you advised in (a)Explanation / Answer
a. For expansion strategy:
Net return = 0.6*500 + 0.3*400 - 0.1*150
= $405
For building new plant:
Net return = 0.6*700 + 0.3*200 - 0.1*300
= $450
For subcontracting:
Net return = 0.6*200 + 0.3*150 - 0.1*50
= $160
Since net return for building a new plant is highest, i.e. $450, hence course of action should be to build a new plant.
b. For expansion strategy:
Net return = 0.3*0.6*500 + 0.7*0.3*400 - 0.4*0.1*150
= $168
For building new plant:
Net return = 0.3*0.6*700 + 0.7*0.3*200 - 0.4*0.1*300
= $156
For subcontracting:
Net return = 0.3*0.6*200 + 0.7*0.3*150 - 0.4*0.1*50
= $65.5
Since net return for expansion strategy is highest, i.e. $168, hence course of action should be to expand.
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