Problem 1:
Your company is preparing to meet increased demand over the next three years. To do so, its CFO has determined that you should build a new manufacturing facility, either in Bay Town or in Pasadena. The lender will offer different rates for these two plans; for the Bay Town facility it offers a rate of 14% and for Pasadena 18%. The costs to build the factories are identical, but different tax and labor circumstances mean that the profit per unit in Pasadena will be $1.11 whereas in Bay Town it will be 1.06. Assuming that the current demand for your product is 1.5 million units, and that the demand will increase by 5% each future period, conduct a Net Present Value decision-making exercise and make a recommendation on which facility to build.
Problem 2
Using the previous example (problem 1), conduct a decision tree analysis of this problem assuming that there is instead a 65% chance of demand increasing by 20% and a 35% chance of demand decreasing by 30% (instead of the steady 5% increase seen in problem 1).
Draw both decision trees and show the process of making this decision.
Which offer should you accept, if any?