Question

A firm must choose between remaining where it is, with current capacity, and building a new facility with 50% more capacity. The probability of high demand is estimated to be 75%. The current facility would provide $100,000 profit if there is high demand or $50,000 profit if there is low demand. The replacement facility would provide $160,000,000 profit if there is high demand but would only break even if there is low demand. What is the expected value of each option? (Enter your answer without using a comma separator, e.g. 5275.)
?For replacement facility = $____

For current facility = $____

Answer 1

Following are to be noted :

Probability of high demand = 0.75

Therefore, probability of low demand = 1- 0.75 = 0.25

Expected value of current facility

= Probability of high demand x Profit under high demand + Probability of low demand x Profit under low demand

= 0.75 x 100,000 + 0.25 x 50,000

= $75,000 + $12500

= $87500

Expected value of replacement facility

= Probability of high demand x Profit under high demand + Probability of low demand x Profit under low demand

= 0.75 x 160,000,000 + 0.25 x 0

= $120,000,000

EXPECTED VALUE OF CURRENT FACILITY = $87500

EXPECTED VALUE OF REPLACEMENT FACILITY = $120000000