A company which manufactures compact discs has found that demand for its product has been increasing

A company which manufactures compact discs
has found that demand for its product has been increasing rapidly over the last
12 months. A decision now has to be made as to how production capacity can be
expanded to meet this demand. Three alternatives are available:

(i) Expand the existing plant;

(ii) Build a new plant in an industrial
development area;

(iii) Subcontract the extra work to another
manufacturer.

The returns which would be generated by
each alternative over the next 5 years have been estimated using three possible
scenarios:

(i) Demand rising at a faster rate than the
»

A company which manufactures compact discs
has found that demand for its product has been increasing rapidly over the last
12 months. A decision now has to be made as to how production capacity can be
expanded to meet this demand. Three alternatives are available:

(i) Expand the existing plant;

(ii) Build a new plant in an industrial
development area;

(iii) Subcontract the extra work to another
manufacturer.

The returns which would be generated by
each alternative over the next 5 years have been estimated using three possible
scenarios:

(i) Demand rising at a faster rate than the
current rate;

(ii) Demand continuing to rise at the
current rate;

(iii) Demand increasing at a slower rate or
falling.

These estimated returns, which are
expressed in terms of net present value, are shown below (net present values in
$000s):

(a) The company’s marketing manager
estimates that there is a 60% chance that demand will rise faster than the
current rate, a 30% chance that it will continue to rise at the current rate and
a 10% chance that it will increase at a slower rate or fall. Assuming that the
company’s objective is to maximize expected net present value, determine

(i) The course of action which it should
take;

(ii) The expected value of perfect
information.

(b) Before the decision is made, the
results of a long-term forecast become available. These suggest that demand
will continue to rise at the present rate. Estimates of the reliability of this
forecast are given below:

p(forecast predicts demand increasing at
current rate when actual demand will rise at a faster rate) = 0.3

p(forecast predicts demand increasing at
current rate when actual demand will continue to rise at the current rate) =
0.7

p(forecast predicts demand increasing at
current rate when actual demand will rise at a slower rate or fall) = 0.4

Determine whether the company should, in
the light of the forecast, change from the decision you advised in (a).

(c) Discuss the limitations of the analysis
you have applied above and suggest ways in which these limitations could be
overcome.

»

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