Question

(5) A company which manufactures compact discs has found that demand for its product has been increasing rapidly over the last 12 months. A decision now has to be made as to how production capacity can be expanded to meet this demand. Three alternatives are available: (1) Expand the existing plant. (11) (111) Build a new plant in an industrial development area. Subcontract the extra work to another manufacturer. The returns which would be generated by each alternative over the next 5 years have been estimated using three possible scenarios: Demand rising at a faster rate than the current rate. Demand continuing to rise at the current rate (111) Demand increasing at a slower rate or falling. These estimated returns, which are expressed in terms of net present value, are shown below (net present values in $000s):

Answer 1

(a) gemand rising faster (a) pemand mising 60% chance and unent nate: 30 % chance demand falling = 10% chance In expanding alternative, the expected return is m = 500 x 0.6 + 400 x 0.3 - 150 xol' In building new plant alternative, the expected return is : 405 etour = 700 x0.6 + 200 x 0 3 - 300 x 0.1 2450 In subcontracting alternative, the expected return is 0.6 + 150 *0.3 - 30X0.1 2 200 = 160 Sul Building new plant option is better as more expected (n) Expected value = 450

(b) (fonecart prodiets demand ineneasing and current nate while demand will nire at fasten nate) : 0.3 i P ( demand rising af fasten nate) .1-0.3 Bitli P (foncast prediction while demand at wennent rate), 0.7 ne p ( demand ruising at current rate) diten e (honecast prediction while demand falling), die yp (demand falling) 1-0.4 0. ..2 Demand rising abor demand at current rate : 30y. In expanding return al l and en na 23 Oy demand falling = 10x sont d. l'io min = soo x 0.78 0.6 + yoo x 0.1*0.3 -150xd 6x0.1 = 285 en building new plant, 2 700x 0.78 0.6 t goox 0.78 0.3 - 300 x 0.6 0.1 2 318 In sub contracting adida s - 200 40.1% 0.6 + 150 x 0.703 - Sox 0.6 10. - 112.5 Decision will be same as a cas de building new plant because return is mortelles Same De