NPV TO DETERMINE OPTIMAL PLANT INVESTMENT PLAN, FACING DEMAND UNCERTAINTY

GOAL: Combine decision analysis with NPV to evaluate a problem of choice under uncertainty.

GENERAL PROBLEM DESCRIPTION:

You still work for a major materials manufacturer. Your boss examined the preliminary NPV analysis, but has some concerns. While initial orders of two million parts per year are guaranteed, there is some uncertainty regarding the future rate of demand growth. Your initial assessment used a single growth forecast. You have now been asked to consider the implications if the growth rate is twice the estimate, or if no growth occurs. Further details are provided below.

PROBLEM OUTLINE:

Same basic details as in Exercise 1.
Initial demand always 2 million parts per year.
Demand growth rate uncertain:
High: 3 million parts per year;
Medium: 1.5 million parts per year;
Low: 0 parts per year.
Each growth scenario has an equal likelihood of occurring (probability = 1/3).
Maximum demand remains 10 million parts per year.
Use a discount rate of 10 percent and consider 10 years of sales.

ACTIONS:

You should refer to the spreadsheet you developed for Exercise 1. For each possible growth rate, calculate the NPV for Plan A, Plan B with a capacity addition in Year 3, and Plan B without a capacity addition in Year 3.
Calculate the expected NPV for each investment plan (probability weighted average).
Build a decision tree which compares Plan A and Plan B (with and without the capacity expansion). Here the expansion decision is assumed to be fixed in advance.
Revise the decision tree to reflect the fact that the expansion decision is made in Year 3.
Build a decision tree that can be used to estimate the value of a test which predicts demand growth with certainty.
Your report should include the three decision trees and a brief (one page) summary with recommendation and discussion of issues.
Additionally, note that the overall expected demand in any given year is exactly that estimated in Exercise 1 (i.e. expected growth rate equals 1.5 million parts per year). However, the expected NPV calculated in Exercise 2 does not equal the NPV calculated using the expected growth rate. Explain this observation, and its implications (briefly).

NOTE FOR TREEAGE USERS:

(see TreeAge Manual or Instructions Summary for more detail)

When you create active links between TreeAge and your spreadsheet, make sure that you have gathered all your results on the same sheet and that you have named the cells.
If you enter the probabilities as variables, you will be able to perform sensitivity analyses on these uncertainties.
TreeAge enables you to check for your EVPI calculation.

The detailed instructions, data and files necessary for the computer exercises are also available on the Engineering System Studies web-site, at http://command.mit.edu/ESD.000 - Optimal Plant Investment (prior registration is necessary).