A brand new facility is being built to manufacture micro chips and they are unsure of size to build if it’s a Bigger or a Smaller size. The cost of constructing a Bigger facility is $250 million and the cost of constructing a smaller facility is $150 million. Company believes a 60% chance exists that the demand for this electronics will be high and a 40% chance that demand will be low. The following table summarizes the net present value of all future cash flows the company expects to receive for each factory size and demand combination Factory Size High Demand Low Demand Bigger $400 million $150 million Smaller $180 million $160 million Suppose that before making the factory size decision, company undertakes a survey to figure out if its feasible. This survey would cost $4 million to conduct. Assume that the results of this survey will indicate either a favorable or unfavorable attitude toward the new electronics. Company has conducted such a survey for other similar vehicles 30 times in the past, with the following results: Survey Results High Demand Low Demand Favorable 7 3 Unfavorable 4 6 Construct decision tree to decide course of action that will maximize the expected Net Present Value and if the company should conduct the survey? What size of facility should they build? Use TreePlan to solve the tree to determine best course of action and total expected NPV Suppose cost of survey is not $4 million but some quantity “x”. What is the largest “x” for which the company should conduct the survey. Suppose the company is risk averse and wishes to take that into account while making the decision. Company would just barely be willing to accept a hypothetical 50-50 gamble that would net $100 million if it succeeds but lose $50 million if it fails. Using TreePlan and the exponential utility function to consider the level of risk aversion suggested by company willingness to undertake the gamble, re-solve the decision tree and describe the explanation.
