A Chemical Company Is Trying to Decide Whether to Build

Essay

A chemical company is trying to decide whether to build a pilot plant now for a new chemical process or to build the full plant now.If they build a pilot plant now, they could expand it later to a full plant or license the plant to another company.It would cost them $2 million to build the pilot plant and another $2 million later to expand it.If they build the full plant now it would cost $3.5 million to construct.The returns they expect to get from the full production plant depend upon the market.
They estimate there is a 60% chance the market will be robust, a 30% chance it will remain stable, and a 10% chance it will become stagnate.The returns are estimated to be $5 million if it is robust, $3 million if it is stable, and $1 million if it is stagnate.Before they expand the pilot plant, they plan to conduct a comprehensive study.Based on past experience, they expect the study to report a 60% chance of favorable outcome for expansion and a 40% unfavorable chance.In either case they will have to decide whether to expand to a full plant or license the pilot plant.If the report is favorable and they license it, they expect to get $3 million.However, if the report is unfavorable and they license it, they will only get $1 million.
a.Using decision tree analysis, what is the expected value for building the full plant now?
b.Using decision tree analysis, what is the value of the decision on expanding the pilot plant assuming the report is favorable?
c.What should the company do and what is the expected value of that decision?