CMI, a manufacturing company, wants to build a new plant. It offers to pay Five
ID: 347858 • Letter: C
Question
CMI, a manufacturing company, wants to build a new plant. It offers to pay Five Cities Construction 3 million dollars to build the plant. CMI estimates, based on projected demand for its product, that the net present value of the plant upon completion would be 3.2 million. Currently, the cost to Five Cities of building the plant will be 2.8 million, but both parties know that there is a chance that prices of some key construction materials will rise after the contract is signed, making the cost of building the plant 3.1 million. Assume that the chance of this happening is low enough that Five Cities is still willing to accept the contract. Finally, assume that contracts are enforced with expectation damages.
The diagram below represents this situation as a game between CMI and Five Cities, CMI moves first, deciding whether to offer the contract. Five Cities moves next, deciding whether or not to accept the contract. Then “Nature” moves, deciding whether Five Cities’ cost will be low (2.8) or high (3.1). Five Cities then moves again, deciding whether to perform or to breach.
a. Explain why CMI is comfortable making this contract, even though it knows that Five Cities will be tempted to breach if costs turn out to be high.
b. The payoffs to different outcomes are in the parentheses at the bottom of the tree. For example, .2 is the payoff to CMI if cost is high and Five Cities chooses to perform, and “a” represents the payoff to Five Cities if costs are high and Five Cities chooses to perform. List the payoff numbers that correspond to the letters a through d.
c. If costs are high, would the socially optimal outcome be for Five Cities to perform, or for Five Cities to breach? Explain.
d. Would Five Cities perform or breach if cost turned out to be high? Explain.
CMI Don't Offer Contract Offer Contract Five Cities (o, o) Accept Don't Accept Nature (0, 0) High Cost Low Cost Five Cities Perform Breach Perfor Breach (b, 2) (.2, cExplanation / Answer
Part A ) CMI is comfortable making the contract because they are in a Win -Win position. They are paying only 3 Million $ for an Asset whose Net present Value is 3.2 Million $. So building the plant results in a profit of 0.2 Million $ as increased asset Value. And if Five Cities Construction bails out still they will be getting 0.2 Million $ as liability. Another aspect is that there is incentive for Five Cities Construction to build the plant as their loss in case of high cost is only 0.1 Million $ while expectation damages are 0.2 million $
Part B) Payoffs For High Cost , Cost 3.1 Million $ , NPV of Asset if created = 3.2 million $ , Amount paid to FCM = 3 million$ Hence payout if FCM accepts and performs = 3.0-3.1= - 0.1 Million $ =a
payout if FCM accepts and does not perform = .2 million $ as expectation damages (b)
Payout for Low Cost if FCM accepts and perform = 3.0-2.8 = 0.2 million $ (c)
Payout for low cost if FCM accepts and does not perform = 0.2 million $ (expectation damages) (d)
Part C and D ) Here you have to understand that if Costs turn out to be high which is 3.1 million $ then FCM incurs a loss of 0.1 million $. However if they breach then they have to pay expectation damages as per contract which are 0.2 million $. Now this is less than 0.1 million $. So regardless of the cost the socially optimal outcome for FCM is to perform the contract