Decision tree analysis and the expected payoff criterion

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Reference no: EM132128684

MKGP has just introduced a new product line. It is considering three options regarding its new product line: (1) subcontract, (2) expand existing facility, or (3) build a new facility. A consultant’s report indicates a 30 percent probability that the demand will be low, a 50 percent probability that the demand will be medium, and a 20 percent probability that the demand will be high.

If MKGP decides to subcontract and demand turns out to be low, the net present value of the returns will be $550,000. If the firm decides to subcontract and the demand turn out to be medium, the firm has two options available: (1) do nothing with a net present value of 660,000 or (2) expand its operations. If the firm decides to expand its operations, there is 35 percent chance of earning a net return of $620,000 and a 65 percent chance of earning a net return of $740,000. If the firm decides to subcontract and demand turns out to be high, then the firm has three options available: (1) do nothing, with a net present value of $620,000; (2) expand, with a net present value of $810,000; or (3) build a new facility, with a net present value of $890,000.

If MKGP decides to expand and the demand turns out to be low, then the company has two choices: (1) do nothing, with a net present value return of $360,000, or (2) use the expansion for other purposes. Depending on the result of negotiations regarding expansions, there is 65 percent chance that the firm uses the expansion for manufacturing another product and 35 percent chance that it will use it for the purposes of warehousing and storage. The net present value of using the expansion for other manufacturing purposes is $700,000, and the net present value of using the expansion as a storage facility is $400,000.

If MKGP decides to expand and the demand is medium, then the expected net return is $510,000. If the firm decides to expand and the demand is high, then the company has the following options available: (1) do nothing (net present value return of $810,000), (2) subcontract (net present value return of $740,000), or (3) build a new facility (net present value return of $840,000).

If MKGP decides to build a new facility and the demand is low, then the company has two choices: (1) do nothing, with an expected net present return of $340,000, or (2) use the new facility for other purposes. Depending on the result of negotiations regarding facilities, there is 42 percent chance that the firm uses the new building for manufacturing another product and 58 percent chance that it will use it for the purposes of warehousing and storage. The net present value of using the new building for manufacturing another product is $670,000 and the net present of using the new building as a storage facility is $490,000. If the firm decides to build a new facility and the demand is medium, then the company has a 35 percent chance of earning a net return of $600,000 and a 65 percent chance of earning a net return of $730,000. If the firm decides to build a new facility and the demand is high, then net present value of the return is $1,200,000.

Using decision tree analysis and the Expected Payoff (EP) criterion, make a recommendation for MKGP.

Reference no: EM132128684

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