Question

The Managing Director of a company is deciding whether to build a large or small additional production facility to ensure that the company has sufficient operating capacity to satisfy current and future sales demand. In consultation with the company’s senior management accountant, the following two possible scenarios in terms of the net present value of future cash flows from the alternatives are being considered. Possible Outcome Low Demand High Demand Action Build small facility £700,000 £520,000 Build large facility £420,000 £2,100,000 It is estimated that there is a 60% probability that demand will be low and a 40% probability that demand will be high. (c) Using the expected value decision rule, advise on the most profitable course of action. (10 marks)

Answer 1

Solution Available alternatives - (a) Build Sunnall Facility (6) Build Large Facility In case of how Dernand £ 700,000 € 420,000 High Demand £500,000 2,100,000 Probability of High demound = 40% Probability of how demand = 60% nie. 0-4 ( 40 = 100) le 0.6 (60 + 100) Computation of expected monetary value A weighted average of the payoffe to decide on the alternative. Alternatives Low Demand High demand Build Small Facility f 700,000 € 520,000 Build harge € 420,000 £2,100,000 Probability 0.6 0.4 : Expected monetary value (Small facility) = £700,000 x 0.6 + £520,000 x 0-4 = € 420,000 +€ 208,000 = £ 628,000

Expected monetary value (large facility] - € 420,000 x0.6 + £2,100,000*0.4 - £2,52,000 + £ 840,000 = € 1,092,000 From the above analysis it is clear that the expected monetary value of building a large facility (€1,092,000) is higher than building a small facility C £628,000). Hence, the Managing director of the company should go ahead on building the larger facility. Further clarifications :- Calculation of expected monetary value :- In the first working of small facility, we have multiplied £700,000 with 0.6 because the probabity is 0.6 as it has low demand. To get the expected monetary value we have to find out the total in weighted average ie for both the situations in this care for low demand and high demand.