The Weston Co. is thinking of building a plant to manufacture a new product recently developed by…

The Weston Co. is thinking of building a plant to manufacture a new product recently developed by its R&D department. Several alternatives are available to the firm regarding the size of the plant. The company can construct a large plant, which will cost Rs 500,000. Under different demand conditions the cash flows with associated probabilities are expected to be as follows:

                                              Large Plant

                                                                          Cash inflow (Rs)

            Demand condition     Probability               year 1–10

            High                                 0.50                          125,000

            Medium                           0.40                          100,000

            Low                                 0.10                            50,000

The alternative to building a large plant is to build a smaller plant for Rs 200,000 now, with an option to build an additional plant after two years, if the product achieves sufficient success. The small plant has a capacity to maintain Rs 80,000 in cash flows. Under high or medium demand the plant will be fully utilised.

 

 

The expected cash flows with associated probabilities are as follows:

                                               Small Plant

                                                                          Cash inflow (Rs)

            Demand condition     Probability                year 1–2

            High                                 0.50                            80,000

            Medium                           0.40                            80,000

            Low                                 0.10                            40,000

After two years, the company can review the situation to expand the smaller plant. If the company experiences a high initial demand for the first two years, a Rs 300,000 addition could be built, increasing yearly revenue potential by Rs 60,000.

The company estimates the net cash flows with associated probabilities under different demand conditions as follows:

High Initial Demand: Additional Plant of Rs 300,000

            Demand                                                Cash inflow (Rs)
            condition                    Probability               year 3–10

            High                                 0.60                          140,000

            Medium                           0.30                          110,000

            Low                                 0.10                            80,000

If only medium demand was achieved in the first two years then a Rs 150,000 addition would be considered. The expected cash flows and probabilities are as follows:

            Medium Initial Demand: Additional Plant of Rs 150,000

            Demand                                                Cash inflow (Rs)
            condition                    Probability               year 3–10

            High                                 0.60                         110,000

            Medium                           0.30                           80,000

            Low                                 0.10                           25,000

The company also considers the possibility of not building any addition regardless of the level of demand.

Design a decision tree and solve for the most profitable alternative. Assume a 10 per cent discount rate and that the plants do not have any salvage value.

 

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