Question

A company is planning a plant expansion. They can build a large or small plant. The payoffs for the plant depend on the level of consumer demand for the company's products. For the large plant, the company expects $85 million in profit if demand is high and $35 million if demand is low. For the small plant, the company expects $54 million in profit if demand is high and $19 million if demand is low.

The company believes that there is a 72% chance that demand for their products will be high and a 28% chance that it will be low.

Construct a payoff and regret matrix based on the given information.

1. What is the decision according to the EMV criterion? Please provide work.

2. Is the decision sensitive to the demand assumptions given?

Answer 1

Decision by evm (expected monetary value)

Big machine    (in million dollars)

Demand	Cash flow	Probability	Probability * cash flow
High	85	72%	61.2
Low	35	28%	9.8
		Total	71

Small machine (in million dollars)

Demand	Cash flow	Probability	Probability *cash flow
High	54	72%	38.88
Low	19	28%	5.32
		Total	44.2

So company should go for big machine with probability of 72% to get 85 million dollars

And average probable cash flow of $71million instead of average probable cash flow of 44. 2 million

So company go for big machine

2) Yes, Decision is sensitive to demand assumption (if demand is at such low level where small machine run under capacity there would be big machine more costly)