A Company Is Trying to Decide Whether to Build a Large

question 42

Essay

A company is trying to decide whether to build a large plant or a small plant to supply future sales of a new product. However, it is uncertain about the market response to the product; whether demand will be strong or weak. According to the firm's marketing department, the probability of strong demand is .3 and of weak demand is .7. The table below lists the firm's profits (in millions of dollars) depending on plant capacity and the market response:
(a) The company must make its plant decision now, before it will know what the market response will be. Which plant size maximizes its expected profit?
(b) Now suppose the company has a third option: building a modular plant. This is the same size as the small plant but is built so it can be expanded to the size of the large plant at a later date. The modular plant costs $4 million more to build than the small plant, but it allows the company the flexibility to observe the market response to the new product and immediately expand its capacity if demand warrants it (Note: If the modular plant is expanded, the firm’s total cost is also $4 million more than building a large plant in the first place). Should the company choose to build the modular plant?
(c) Suppose that the firm can take a small-scale market survey that will help it forecast market demand. The test has two possible outcomes: positive or negative. In the past, products that went on to enjoy strong demand received positive test market scores in 4 of 6 cases: Pr(+|S) = 2/3. Products generating weak demand received negative test results in 5 of 7 cases: Pr(–|W) = 5/7. Compute the revised probabilities, Pr(S|+) and Pr(S|–).

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Definitions:

Operating Cost

Expenses associated with the day-to-day functions of a business, including costs for rent, utilities, and payroll.

Useful Life

The estimated period over which an asset is expected to be usable for its intended purpose, affecting depreciation calculations.

Economic Value

A measure of the benefit provided by a good or service to an economic agent, often quantified in terms of willingness to pay or the added utility it offers.

Operating Cost

Expenses related to the day-to-day functioning of a business, such as rent, utilities, salaries, and equipment maintenance.