Problem

Management of a chemical company is trying to decide whether to build a pilot plant now for a new chemical process or to build the full plant now. If they build the full plant now it would cost $3.5 million to construct. The returns they expect to get from the full production plant depend upon the market. They estimate there is a 60% chance the market will be robust, a 30% chance it will remain stable, and a 10% chance it will become stagnant. The returns are estimated to be $5 million if it is robust, $3 million if it is stable, and $1 million if it stagnates. If they build a pilot plant now, they could expand it later to a full plant or license the plant to another company. It would cost them $2 million to build the pilot plant and another $2 million later to expand it. Before they expand the pilot plant, they plan to conduct a comprehensive study. Based on past experience, they expect the study to report a 60% chance of favorable outcome for expansion and a 40% unfavorable chance. In either case, they will have to decide whether to expand to a full plant or license the pilot plant. If they expand, they will have the same returns and same market conditions as if they build the full plant now. If the report is favorable and they license it, they expect to get $3 million. However, if the report is unfavorable and they license it, they will only get $1 million.

Develop a decision tree for the chemical company and indicate the probabilities and outcomes.

Using expected values, recommend a course of action.