Excellent Manufacturing Case Study Solution

Excellent Manufacturing

In each part below, specify the corresponding decision tree along with its branch probabilities and payoffs. Also answer the questions in each part.

A. Base Case

Excellent Manufacturing Company is considering a new product introduction that calls for an investment of $8 million. The company faces uncertainty about future revenues and costs. Expected future revenues will be $2 million per year if product demand is high, $1.25 million per year if demand is medium, and $.5 million if demand is low. Each of the three demand scenarios is equally likely, i.e., the probability is one-third that demand will be high, one-third that it will be medium, and one-third that it will be low. There are two possible cost scenarios that depend on, say, material prices and maintenance costs: with probability of one-half, the cost will be $0.3 million per year (low), and with probability one-half, it will be $0.8 million per year (high). Low costs could be realized if, say, material costs are low and machine breakdowns are infrequent, while costs could be higher if material prices increase and the machinery needs frequent maintenance. All costs and revenues are perpetual and after tax. Thus, the revenue (costs) are annual amounts that Excellent will receive (pay) each year forever. Assume that Excellent's cost of capital is 10 percent. What should Excellent do?
Hint: Convert all costs and revenues to present values using the cost of capital as the interest rate (e.g. the present value of $2 million per year perpetually is $2/.1 = $20 million).

B. Market Research Option

Excellent Manufacturing has to decide whether to spend money on market research to find out the level of demand. If it spends nothing, it will not know which demand scenario to anticipate and will view its expected revenue as the average of the three