The president of ChemTech is trying to decide whether to start a new product line or purchase a small company. It is not financially possible to do both. To make the product for a 3-year period will require an initial investment of $250,000. The expected annual cash flows with probabili­ties in parentheses are $75,000 (0.5), $90,000 (0.4), and $150,000 (0.1). To purchase the small company will cost $450,000 now. Market surveys indicate a 55% chance of increased sales for the company and a 45% chance of severe decreases with an annual cash flow of $25,000. If decreases are experienced in the first year, the company will be sold immediately (during year 1) at a price of $200,000. Increased sales could be $100,000 the first 2 years. If this occurs, a deci­sion to expand after 2 years at an

additional investment of $100,000 will be considered. This expansion could generate cash flows with indi­cated probabilities as follows: $120,000 (0.3), $140,000 (0.3), and $175,000 (0.4). If expansion is not chosen, the current size will be maintained with anticipated sales to continue. Assume there are no salvage values on any investments. Use the description given and a 15% per year return to do the following:

(a) Construct a decision tree including all values and probabilities.
(b) Determine the expected PW values at the “expansion/no expansion” decision node after 2 years provided sales are up.
(c) Determine what decision should be made now to offer the greatest return possible for ChemTech.
(d ) Explain in words what would happen to the expected values at each decision node if the planning horizon were extended beyond 3 years and all cash flow values continued as forecasted in the description.


(a) Construct the decision tree



(b) At D2, compute PW of cash flows and E(PW) using probability values.



Expansion option



(PW for D2, $120,000) = –100,000 + 120,000(P/F,15%,1) = $4352

(PW for D2, $140,000) = –100,000 + 140,000(P/F,15%,1) = $21,744

(PW for D2, $175,000) = $52,180



E(PW) = 0.3(4352 + 21,744) + 0.4(52,180) = $28,700



No expansion option



(PW for D2, $100,000 = $100,000(P/F,15%,1) = $86,960

E(PW) = $86,960

Conclusion at D2: Select no expansion option



(c) Complete rollback to D1 considering 3 year cash flow estimates.



Produce option, D1



E(PW of cash flows) = [0.5(75,000) + 0.4(90,000) + 0.1(150,000](P/A,15%,3)

= $202,063

E(PW or produce) = cost + E(PW of cash flows)

= -250,000 + 202,063

= $-47,937



Buy option, D1



At D2, E(PW) = $86,960

E(PW for buy) = cost + E(PW of sales cash flows)

= -450,000 + 0.55(PW sales up) + 0.45(PW sales down)

PW Sales up = 100,000(P/A,15%,2) + 86,960(P/F,15%,2)

= $228,320

PW sales down = (25,000 + 200,000)(P/F,15%,1)

= $195,660



E(PW for buy) = -450,000 + 0.55 (228,320) + 0.45(195,660)

= $-236,377



Conclusion: E(PW for produce) is larger than E(PW for buy); select

produce option.



Note: Both returns are less than 15%, but the return is larger for

produce option.



(d) The return on the initial investment would increase, but it would increase faster for the produce option.

Trades & Technology

You might also like to view...

When truing a grinding wheel, it is essential to start:

A) At the low (closest to the spindle) point on the wheel B) At the highest point on the wheel C) Wherever the wheel happens to be when you set the diamond at an approximate position for dressing D) At a point about midway between high and low

Trades & Technology

When pairs of letters need to be spaced more closely to appear correctly, they are called kerned pairs

Indicate whether the statement is true or false

Trades & Technology

If water in a cup is 10°C and the cup is 20°C, which way will the heat travel according to the second law of thermodynamics?

A) Heat will travel in each of the two directions. B) Heat will not travel from one object to another. C) Heat will travel from the water to the cup. D) Heat will travel from the cup to the water.

Trades & Technology

Stairs provide easy access between the floors of a building; one type, ____, run straight from one elevation to the next with no turns.

A. straight stairs B. L-shaped stairs C. double-L stairs D. U-shaped stairs

Trades & Technology