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    Replacement Analysis using expected values

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    A company manufactures specialty devices for machinery. One particular device has reached maturity, and the company is considering whether to replace it with a newer model. Technologies have not changed dramatically so the new device would have similar functionality to the existing one but would be smaller and lighter in weight.

    The firm's three choices are to keep the old model, design a replacement with internal resources and purchase a new design from a firm that is one of it suppliers. The market for these devices will be either "receptive or "neutral" of the replacement model. The financial estimates are as follows: Keeping the old design will yield a profit of $6 million dollars. Designing the replacement internally will yield $10 million if the market is "receptive" but a $3 million loss if the market is "neutral." Acquiring the new design from the supplier will profit $4 million under "receptive," $1 million under "neutral. The company feels that the market has a 70% chance of being "receptive: and a 30% change of being "neutral".

    Calculate expected value for all courses of action and what actions yield the highest expected value?

    A. There are three possible choices here.
    B. If they stay with old design, the profit will be $6 million.
    C. The EMV of developing the replacement internally is $6.1 million.
    D. The company should choose the highest value, and develop a replacement product design with internal resources.

    There could be more than one correct answer.

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    Solution Preview

    Keeping the old Model : $6M

    Designing replacement internally: $10M x 70% + $-3M x 30% = $6.1M

    Acquiring the new design ...