A Chemical Company Is Trying to Decide Whether to Build

question 22

Essay

A chemical company is trying to decide whether to build a pilot plant now for a new chemical process or to build the full plant now.If it builds a pilot plant now,it could expand later to a full plant or license the plant to another company.It would cost $2 million to build the pilot plant and another $2 million later to expand it.If the company builds the full plant now,it would cost $3.5 million to construct.​
The returns the company expects to get from the full production plant depend on the market.There is a 60% chance the market will be robust,a 30% chance it will remain stable,and a 10% chance it will become stagnate.The returns are estimated to be $5 million if it is robust,$3 million if it is stable,and $1 million if it is stagnate.​
Before the company expands the pilot plant,it plans to conduct a comprehensive study.Based on past experience,it expects the study to report a 60% chance of favorable outcome for expansion and a 40% unfavorable chance.In either case,it will have to decide whether to expand to a full plant or license the pilot plant.If the report is favorable and the company licenses it,the company expects to get $3 million.However,if the report is unfavorable and the company licenses it,the company will only get $1 million.​
Develop a decision tree for this problem and determine the optimal decision strategy.

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Definitions:

Financial Statement

A formal record of the financial activities and position of a business, person, or other entity, typically including income statement, balance sheet, and cash flow statement.

Permanent/Temporary

Terms used to differentiate between accounts that remain open over fiscal periods (permanent) and those closed at the end of a period (temporary).

Normal Balance

The side of an account (debit or credit) on which increases in the account are recorded, depending on the account type.

Financial Statement

Reports that provide an overview of a company's financial condition at a specific time, including income statement, balance sheet, and cash flow statement.