Q1. The manager of the dissolving company has to decide whether to build a small or a

Fantastic news! We've Found the answer you've been seeking!

Question:

Q1. The manager of the dissolving company has to decide whether to build a small or a large plant to manufacture a new product with an expected market life of 10 years. The decision hinges partly on the size of the market and the company can obtain for the product. Demand may possibly be high during the first 2 years but, if many of the initial users find the products unsatisfactory, the demand could then fall to a low level thereafter. High initial demand might alternatively indicate the possibility of a sustained high-volume market. If the demand is initially high and remains so and the company finds itself with insufficient capacity within the first 2 years, competitive products will certainly be introduced by other manufacturers.

If the company initially builds a big plant, it must live with it for the whole 10 years, whatever the size of the market demand. If it builds a small plant, there is an option of expanding the plant in 2 yearsâ?? time, an option that it would only take up if demand were high during the introductory period. If a small plant is built initially and demand is low during the introductory period, the company will maintain operations in the small plant and make a good profit on the low-volume throughput.

The manager is uncertain as to the action he should take. The company grew rapidly during the early 1990s, keeping pace with the chemical industry generally. The new product, if the market turns out to be large, offers the company a chance to move into a new period of extremely profitable growth. The development department, particularly the development project engineer, is anxious to build the large-scale plant in order to exploit the first major product development the department has had in some years.

The chairman, a principal stockholder, is wary of the possibility of having a large amount of plant capacity lying idle. He favors a smaller plant commitment, but recognizes that possible later expansion to meet high volume demand would, overall, require more investment and be less efficient to operate. The chairman also recognizes that, unless the company moves promptly to fill the demand which develops, once the product is on the market, competitors will be tempted to move in with equivalent products.

Various items of information have been obtained, or estimated, by the appropriate managers within the company, and are summarized as follows:

Marketing information

The marketing manager suggests a 60% chance of a large market in the long run and a 40% chance of a low demand, developing initially as follows:

Initially high, sustained high 60%

Initially high, long term low 10%

Initially low, continuing low 30%

Initially low, subsequently high 0%

(b) Annual income

The management accounting section has put forward the following initial estimates:

a large plant with high market volume would yield $1 million annually in cashflow (for 10 years)
a large plant with low market volume would yield only $0.1 million annually because of high fixed costs and inefficiencies.
a small plant with low market demand would be economical and would yield annual cash income of $0.4 million per annum.
a small plant, during an initial period of high demand, would yield $0.45 million per annum, but this would drop to $0.25 million per annum in the long run if high demand continued, because of competition from other manufacturers.
If an initial small plant were expanded after 2 years to meet sustained high demand, it would yield $0.7 million annually for the remaining 8 years and so would be less efficient than a large plant built initially.
If the small plant were expanded after 2 years, but high demand were not sustained, the estimated annual cash flow for the remaining 8 years would be $0.05 million.

Estimates obtained from construction companies indicate that a large plant would cost $3 million to build and put into operation and a small plant would cost $1.3 million initially and an additional $2.2 million if expanded after 2 years.

The managers must decide now upon his initial action. Should he recommend the company to build or not, and if it is to build, should it build big or small? It will be assumed that the firm uses expected monetary value (EMV) as its criterion for decision.