Question

Expando, Inc., is considering the possibility of building an additional factory that would produce a new addition to their 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 "0" wherever required. Enter your answers in millions rounded to 1 decimal place.)
Plans NPV
Small facility $ million
Do nothing million
Large facility million
b. The best decision to help Expando is:_______.
a. to build the large facility.
b. to build the small facility.
c. to do nothing.

Answer 1

a)

small facility:

initial outlay = -$9,000,000

present value of expected cash flows = (0.6 x $9,000,000) + (0.4 x $12,000,000) = $10,200,000

NPV = $10,200,000 - $9,000,000 = $1,200,000

large facility:

initial outlay = -$10,000,000

present value of expected cash flows = (0.6 x $12,000,000) + (0.4 x $15,000,000) = $13,200,000

NPV = $13,200,000 - $10,000,000 = $3,200,000

b) the best option is:

• a. to build the large facility.

the NPV of the large facility is significantly higher than the NPV of the smaller facility, while the required investment is not that different.