Complete the following problems. You may use software, such as Microsoft Visio, to create the decision tree diagram which you then copy and paste into Microsoft Word, or you may simply draw your homework (very neatly please!) on paper and then scan the drawings into Microsoft Word, or take clear, well-lit photos of the drawings and drop those photos into a Microsoft Word file.
1. Your company is preparing to meet increased demand over the next three years (years 0 through 3). To do so, its CFO has determined that you should build a new manufacturing facility, either in Bay Town or in Pasadena. The costs to build in year 0 are identical ($85 million), but the lender will offer different rates for these two plans, which results in different hurdle rates; for the Bay Town facility the hurdle rate is 15.75% and for Pasadena 18.75%. The costs to build the factories are identical, but different tax and labor circumstances mean that the profit per unit (starting in year 1) in Pasadena will be $2.75 whereas in Bay Town it will be $2.63.
Assuming that the current demand for your product is 10.5 million units, and that the demand will increase by 5% each future period, conduct a Net Present Value decision-making exercise and make a recommendation on which facility to build. Draw the decision as a tree and show your calculations.
2. Using the previous example (problem #1), conduct a decision tree analysis of this problem. However, instead of the steady 5% demand increase seen in problem #1, assume that there is a 25% chance of demand increasing by 20%, a 40% chance of demand increasing by 5% and a 35% chance of demand decreasing by 15%. All other aspects of the problem are the same.
a) Draw both decision trees and show the process of making this decision, including your calculations.
b) Which offer should you accept, if any?
3. Using problem 1 again, conduct a different decision tree analysis assuming the following:
- Demand has an 80% change of increasing by 15% and a 20% chance of decreasing by 10%, and
- Profit per unit has a 65% change of remaining flat and a 35% chance of increasing by 5%.
a) Draw both decision trees and show the process of making this decision, including your calculations.
b) Which offer should you accept, if any?