Question

A manager is trying to decide whether to buy one machine or two. If only one is purchased and demand proves to be excessive, the second machine - can be pur­chased later. Some sales will be lost, however, because the lead time for producing this type of machine is 6 months. In addition, the cost per machine will be lower if both are purchased at the same time. The probability of low demand is estimated to be 0.20. The after-tax net present value of the benefits from purchasing the two machines together is $90,000 if demand is low and $180,000 if demand is high.

If one machine is purchased and demand is low, the net present value is $120,000. If demand is high, the man­ager has three options. Doing nothing has a net present value of $120,000; subcontracting, $160,000; and buying the second machine, $140,000.

a. Draw a decision tree for this problem.

b.How many machines should the company buy
initially? What is the expected payoff for this
alternative?

Answer 1