QUESTION # 2 A manufacturing plant has reached full capacity. The company must b

Question

QUESTION # 2 A manufacturing plant has reached full capacity. The company must build a second plant cither small or large - at a nearby location. The demand is likely to be high or low. The probability of low demand is 0.3. If demand is low, the large plant has a present value of $5 million and the small plant, S8 million. If demand is high, the large plant pays off with a present value of $18 million and the small plantwith a present value of only $10 million. However, the small plant can be expanded later if demand proves to be high, for a present value of $14 million. Draw a decision tree for this problem. [12% ] What should management do to achieve the highest expected payoff? [496] a. b.

Explanation / Answer

Answer

Probability of low demand - 0.3

Present value of large plant - $5 million

Based on probabilistic demand, the value = $5 × 0.3 = $1.5 million

Similarly for small plant, the value = 0.3 × $8 million = $2.4 million

Probability of high demand - 0.7

Value for large plant in case of high demand is 0.7 × $18 million = $12.6 million

Similarly, value for small plant = 0.7 × $10 million = $7 million

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