Question

A computer chip manufacturer is considering expanding production to meet possible increases in demand. The company's alternatives are to construct a new plant, expand the existing plant, or do nothing in the short run. It will cost them $1 million to build a new facility and $600,000 to expand their existing facility. The market for this particular product may expand, remain stable, or contract. The marketing department estimates the probabilities of these market outcomes as 0.20, 0.50, and 0.30, respectively. The expected revenue for each alternative is presented in the table below.

	MKT expands	MKT stable	MKT contracts
Build new plant	$1,650,000	$1,000,000	$450,000
Expand plant	$1,000,000	$850,000	$450,000
Do nothing	$0	$0	$0

What course of action is optimal for the computer chip manufacturer? What is the expected profit in that case?

	a.	The company should expand the existing plant, the expected profit is 215,000.
	b.	The company should expand the existing plant, the expected profit is 160,000.
	c.	The company should build the new plant if the market expands.
	d.	The company should build the new plant, the expected profit is 965,000.

Answer 1

The correct option is B

Explanation:

Expected profit from building plant = (0.20)($1,650,000) + (0.50)($1,000,000) + (0.30)($450,000) - $1,000,000 = -$35,000

Expected profit from expanding plant = (0.20)($1,000,000) + (0.50)($850,000) + (0.30)($450,000) - $600,000 = $160,000

Expected profit from doing nothing = (0.20)($0) + (0.50)($0) + (0.30)($0) = $0

Based on the expected profits, the company should expand the existing plant, with an expected profit of $160,000.