# Net Present Value Decision Analysis

A company which manufactures compact discs has found that demand for its product has been increasing rapidly over the last 12 months. A decision now has to be made as to how production capacity can be expanded to meet this demand. Three alternatives are available:

(i) Expand the existing plant; (ii) Build a new plant in an industrial development area;

(iii) Subcontract the extra work to another manufacturer.

The returns which would be generated by each alternative over the next 5 years have been estimated using three possible scenarios: (i) Demand rising at a faster rate than the current rate;

(ii) Demand continuing to rise at the current rate;

(iii) Demand increasing at a slower rate or falling.

These estimated returns, which are expressed in terms of net present value, are shown below (net present values in $000s):

Scenario

Course of Demand rising Demand rising Demand increasing

action faster at current rate slowly or is falling

Expand 500 400 -150

Build new plant 700 200 -300

Subcontract 200 150 -50

(a) The company"s marketing manager estimates that there is a 60% chance that demand will rise faster than the current rate, a 30% chance that it will continue to rise at the current rate and a 10% chance that it will increase at a slower rate or fall. Assuming that the company"s objective is to maximize expected net present value, determine

(i) The course of action which it should take;

(ii) The expected value of perfect information.

(b) Before the decision is made, the results of a long-term forecast become available. These suggest that demand will continue to rise at the present rate. Estimates of the reliability of this forecast are given below:

p(forecast predicts demand increasing at current rate when actual demand will rise at a faster rate) = 0.3 p(forecast predicts demand increasing at current rate when actual demand will continue to rise at the current rate) = 0.7 p(forecast predicts demand increasing at current rate when actual demand will rise at a slower rate or fall) = 0.4

Determine whether the company should, in the light of the forecast, change from the decision you advised in (a).

(c) Discuss the limitations of the analysis you have applied above and suggest ways in which these limitations could be overcome.

#### Solution Preview

(a) The company"s marketing manager estimates that there is a 60% chance that demand will rise faster than the current rate, a 30% chance that it will continue to rise at the current rate and a 10% chance that it will increase at a slower rate or fall. Assuming that the company"s objective is to maximize expected net present value, determine

(i) The course of action which it should take;

According to the table above and the calculation for the future values of each categories. The future values for the Expand/ Demand rising faster is 47; the future values for Build a new plant/Demand rising faster 66.79; the future values for subcontract/ Demand rising faster is 18.51.

In the other categories, the value for Expand/ Demand rising at current rate is 107; the value for Build a new plant / Demand rising at current rate is 53. The value for Subcontract : Demand rising at current rate

Is 40.4.

So it looks like the values of the Expand/Demand rising at ...

#### Solution Summary

This response is a step-by-step solution of a net present value ( NPV) decision analysis.