Decision Tree

A company is preparing to introduce a new product. Demand is uncertain. According to a market research conducted on behalf of the company, it is estimated that the demand can be High (H) with a probability 70% percent and Low (L) with a probability 30%. After the first 2 years if the initial demand is high, there is 15% likelihood that it will drop to Low and 85% likelihood that it will remain High. If, on the other hand, the initial demand is Low, it will remain Low with no chance to of increasing to High.

The company has to select among 2 alternatives.
A) start dynamically making a new big investment worth of 300000$
B) Start conservatively using existing equipment and technology and making a small investment of 100000$. In this case, and if the demand is high, the company may after 2 years make an additional investment to expand its facilities of 220000$.

The expected annual profits (in thousand $) for each scenario for the first 2 years and for the sequential 8 years are provided in tables 1 and 2.

Table 1: Expect profit (in thousand $) for the first 2 years
High demand Low demand
Large Investment 100 10
Small investment 35 30

Table 2: Expect profit (in thousand $) for the 8 sequential years
High demand Low demand
Large Investment 100 10
Expansion 60 5
Small investment 25 30

The company wishes to identify the optimal facility expansion strategy that will maximize the anticipated revenues over a 10 year horizon.