Problem 5-8 Expando, Inc., is considering the possibility of building an additio
ID: 422168 • Letter: P
Question
Problem 5-8 Expando, Inc., is considering the possibility of building an additional factory that would produce a new addition to their product line. The company is currently considering two options. The first is a small facility that it could build at a cost of $7 million. If demand for new products is low, the company expects to receive $11 million in discounted revenues (present value of future revenues) with the small facility. On the other hand, if demand is high, it expects $14 million in discounted revenues using the small facility. The second option is to build a large factory at a cost of $12 million. Were demand to be low, the company would expect $13 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $17 million. In either case, the probability of demand being high is 0.50, and the probability of it being low is 0.50. Not constructing a new factory would result in no additional revenue being generated because the current factories cannot produce these new products. a. Calculate the NPV for the following: (Leave no cells blank- be certain to enter "O" wherever required. Enter your answers in millions rounded to 1 decimal place.) NPV Small facility Do nothing Large facility million million million b. The best decision to help Expando is to build the large facility. to do nothing. to build the small facility.Explanation / Answer
1)
Cost of constructing small facility = $7million
Expected profits if demand is low from small facility = $11 million
Expected profits if demand is high from small facility = $14 million
Probability of low demand = 0.5
Probability of high demand = 0.5
NPV of small facility = P(low demand) * Expected profits for low demand + P(high demand) * Expected profits for high demand - Cost of constructing small facility?
NPV of small facility = 0.5 * 11 + 0.5 * 14 - 7
= $5.5 million
2)
NPV for do nothing is 0.
3)
Cost of constructing large facility = $12million
Expected profits if demand is low from large facility = $13 million
Expected profits if demand is high from large facility = $17 million
Probability of low demand = 0.5
Probability of high demand = 0.5
NPV of large facility = P(low demand) * Expected profits for low demand + P(high demand) * Expected profits for high demand - Cost of constructing large facility?
NPV of large facility = 0.5 * 13 + 0.5 * 17 - 12
= $3 million
Ans b)
The best decision to help Expando is to build the small facility as it has the highest Net present value of $5.5 million.