Problem 4-5 Expando, Inc., is considering the possibility of building an additio

Question

Problem 4-5

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 $6 million. If demand for new products is low, the company expects to receive $10 million in discounted revenues (present value of future revenues) with the small facility. On the other hand, if demand is high, it expects $12 million in discounted revenues using the small facility. The second option is to build a large factory at a cost of $9 million. Were demand to be low, the company would expect $10 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $14 million. In either case, the probability of demand being high is 0.40, and the probability of it being low is 0.60. Not constructing a new factory would result in no additional revenue being generated because the current factories cannot produce these new products.

Calculate the NPV for the following: (Leave no cells blank - be certain to enter "0" wherever required. Enter your answers in millions rounded to 1 decimal place.)

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 $6 million. If demand for new products is low, the company expects to receive $10 million in discounted revenues (present value of future revenues) with the small facility. On the other hand, if demand is high, it expects $12 million in discounted revenues using the small facility. The second option is to build a large factory at a cost of $9 million. Were demand to be low, the company would expect $10 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $14 million. In either case, the probability of demand being high is 0.40, and the probability of it being low is 0.60. Not constructing a new factory would result in no additional revenue being generated because the current factories cannot produce these new products.

Explanation / Answer

a. NPV of Small facility with low demand = -6+10 million = $4million

NPV of Small facility with high demand = -6+12 million = $6million

NPV of small facility = 0.6*4+0.4*6 = 4.8 milion

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NPV of do nothing = cash inflow + cash outflow = -0+0 = $0

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NPV of Large facility with low demand = -9+10 million = $1million

NPV of Large facility with high demand = -9+14 million = $5million

NPV of Large facility = 0.6*1+0.4*5 = 2.6 milion

Small Facility - $4.8 milion

do nothing - $0

Large facility = $2.6 million

b.The best decision to help Expando is to build the small facility

because it has the highest NPV

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