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 $9 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 $12 million in discounted revenues using the small facility. The second option is to build a large factory at a cost of $10 million. Were demand to be low, the company would expect $12 million in discounted revenues with the large plant. If demand is high, the company estimates that the discounted revenues would be $15 million. In either case, the probability of demand being high is 0.40, and the probability of it being low is 0.60. Not constructing a new factory would result in no additional revenue being generated because the current factories cannot produce these new products. a. Calculate the NPV for the following: (Leave no cells blank - be certain to enter "O" wherever required. Enter your answers in millions rounded to 1 decimal place.) Plans Small facility Do nothing Large facility NPV million million m illion b. The best decision to help Expando is to do nothing to build the small facility. to build the large facility.

Answer 1

NPV=TVECF−TVIC

where:

TVECF=Today’s value of the expected cash flows

TVIC=Today’s value of invested cash​

a.

In case of small facility-

NPV in case of low demand=TVECF−TVIC =9 million-9 million=0 million

NPV in case of high demand=TVECF−TVIC =12 million-9 million=3 million

Expected NPV for small facility=Σ (p × Scenario NPV) =(0.6*0 million)+(0.4*3 million)= 1.2 million

In case of large facility-

NPV in case of low demand=TVECF−TVIC =12 million- 10 million=2 million

NPV in case of high demand=TVECF−TVIC =15 million-10 million=5 million

Expected NPV for small facility=Σ (p × Scenario NPV) =(0.6*2 million)+(0.4*5 million)= 1.2 million+ 2 million=3.2 million

In case of No New facility-

NPV= zero

PLANS	NPV
SMALL FACILITY	1.2 MILLION
DO NOTHING	0 MILLION
LARGE FACILITY	3.2 MILLION

b. Best decision is to build large facility as the NPV is more in this case.