Question

2- (60pts, 50pts for graduate students) A European apparel manufacturer has production facilities in Italy and China to serve its European market, where annual demand is for 1.9 million units. Demand is expected to stay at the same level over the foreseeable future. Each facility has a capacity of 1 million units per year. With the current exchange rates, the production and distribution cost from Italy is 10 euro per unit, whereas the production and distribution cost from China is 7 euro. Over each of the next three years, the Chinese currency could rise relative to the euro by 15 percent with a probability of 0.5 or drop by 5 percent with a probability of 0.5. An option being considered is to shut down 0.5 million units of capacity in Italy and move it to China at a one-time cost of 2 million euro. Assume a discount factor of 10 percent over the three years. Do you recommend this option? Construct the decision tree and show your computations clearly. I

Answer 1

C1 X с D E F G H K L M N A Discount factor Current Capacity in Italy = Current Capcity in China = Current Annual Demand = Variable production cost in Italy = Variable production cost in China = Change in capacity Cost of moving capacity B 10% 1,000,000 1,000,000 1,900,000 10.00 7.00 500,000 2,000,000 Assume that we first exhaust production capacity at lower cost facility & then only produce at higher cost facility Scenario 1: No change in Capacity at China & Italy. So 1,000,000 units produced in China and balance 900,000 in Italy Total Cost Year 0 9,000,000 7,000,000 Italy China Year 1 9,000,000 7,350.000 Year2 9,000,000 7.717.500 Year 3 9,000,000 8,103,375 10 NPV $57,529,771 Year 1 Currency Exchange China = m Probability 0.5 0.5 8.05 6.65 7.35 TT Scenario 2: Capacity moved from Italy to China. 1,500,000 units produced in China & balance 400,000 in Italy 5 Year 2 Currency Exchange Probability 0.25 7.72 9.26 0.25 Year 1 Year2 Year 3 China 7.65 7.65 6.32 Total Cost Year 0 4,000,000 12,500,000 0.25 0.25 Italy China 4,000,000 11,025,000 4,000,000 11,576,250 4,000,000 12,155,063 Year 3 Currency Exchange NPV $55,169,562 As NPV of Scenario 2 is less than that of Scenario 1, The option of shifting facility to China is Not Recommended 10.65 8.79 8.79 7.27 8.79 Probability 0.125 8.10 0.125 0.125 0.125 0.125 0.125 0.125 0.125 China 7.27 7.27 6.00