Question

Expando, Inc., is considering the possibility of building an additional factory that would produce a new addition to its 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 $9 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 $8 million. Were demand to be low, the company would expect $9 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $13 million. In either case, the probability of demand being high is .30, and the probability of it being low is .70. Not constructing a new factory would result in no additional revenue being generated because the current factories cannot produce these new products.
1. Calculate the NPV for the following:

Plans NPV
Small facility $million
Do nothing million
Large facility million

2. The best decision to help Expando is:_________

Answer 1

Answer:

Expando, Inc.

1. NPV for the following:

Plans                 NPV

Small facility     $3.5 million

Do nothing         0 million

Large facility     2.2 million

2. The best decision to help Expando is:_________

to build a small facility.

Explanation:

a) Data and Calculations:

                                      Small Facility         Large Facility

Initial investment costs     $7 million            $8 million

Discounted revenues:

Low demand                       9 million              9 million

High demand                     14 million             13 million

Probability of low demand = 0.70

Probability of high demand = 0.30

Expected revenue              10.5 million         10.2 million

                    ($9m * 0.7 + $14m * 0.30)         ($9m * 0.7 + $13m * 0.30)

NPV                                     3.5 million           2.2 million

1. NPV for the following:

Plans                 NPV

Small facility     $3.5 million ($10.5 - $7) million

Do nothing         0 million ($0 - $0) million

Large facility     2.2 million ($10.2 - $8) million