Question

Invenco, Inc, is experiencing a substantial backlog, and the firm's management is considering two courses of action. The first is to arrange subcontracting that it could cost $5 million to establish the logistics and quality control mechanism. If demand for new products is low, the company expects to receive $8 million in revenues with the subcontracting approach. On the other hand, if demand is high, it expects $15 million in revenues with the subcontracting approach. The second option is to build a plant at a cost of $8 million. Were demand to be low, the company would expect $10 million in revenues with the plant. If demands are high the company estimates that the discounted revenues would be $20 million. In either case, the probability of demand being high is .60, and the probability of it being low is .40. Not constructing a new factory would result in no additional revenue being generated because the current factories cannot produce these new products. Construct a decision tree to help Invenco make the best decision. What is the expected net profit for building a plant?

Answer 1

EV at different nodes:

At node 2,

EV = (0.4×8+0.6×15) - 5

= 12.2 - 5

= 7.2 million

At node 3,

EV = (0.4×10+0.6×20) - 8

= 16 - 8

= 8 million

If there is no action taken, then EV = 0

∵ EV is the highest at node 3,

∴Company would build a plant.