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Old 08-16-2010, 04:03 AM
CF1628 CF1628 is offline
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Join Date: Aug 2010
Location: Perth+AUS
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Default assignment help about uncertainty NPV

hey guys,

I'm a freshman for here, registered just now. A financial major student in Perth, WA.

Currently, I meet a problem when I doing my corporate finance assignment.
Could you guys help me to understand it?

This problem can be generally summarised as following:
"Problem Set Up
CompanyX is considering two alternative investments to build the next generation PC. Its marketing team anticipates rapid growth: expected baseline demand is taken to be 300,000, 600,000, and 900,000 in Years 1, 2, and 3, respectively. However, the company recognises that actual sales may be higher or may be lower.
The company has two mutually exclusive plans to produce 900,000 units:

Plan A
Build a single plant that could produce 900,000 units. Construction would cost $900 million. The company estimates that it will be able to sell each computer for approximately1 $2,000. It also estimates that the incremental manufacturing costs beyond the capital cost of the plant are expected to be approximately1 $1,280 per computer. The salvage value at the end of Year 3 is 0.

Plan B
Build three small 300,000 unit plants, one each year, in an effort to match expected annual demand. The capital expenditure for each small plant is $300 million. The small plant has a unit manufacturing cost of approximately1 $1,500 per computer. This plan gives the company the flexibility not to build successive plants if the demand falls short in the first or second year. The salvage value at the end of Year 3 is approximately1 $300 million."

Note that both plans have drawbacks:
Plan A involves a large amount of excess capacity in the first two years until market demand grows; in addition, there is always a chance that demand falls short of expectations. Variability in demand for a given year can be large. Variability of demand will be discussed in Step 2.

Plan B is less efficient. Also, if the demand grows faster than expected, CompanyX will not have the capacity to meet and take advantage of it.

Question 1
Undertake the calculations in the following 3 Steps. Devise a way to present clearly and simply the results of your calculations. In addition, devise a way to present clearly the calculation methods you used.

Step 1
Based on the forecasted baseline demand expectation without variability, find the NPV for Plan A. In addition, find the NPV for Plan B with an inflexible expansion plan (ie, build one small plant each year regardless of market demand). Based on this first analysis, which plan is better?

Step 2
Now consider the effect of uncertain market demand. Fluctuations about the baseline demand are possible, with enumerable possibilities. For simplicity, only three possibilities of future demand are considered: higher demand than baseline for all 3 years; baseline demand for all 3 years; and lower demand than baseline for all 3 years2. Calculate the maximum, minimum and expected NPVs for both plans. (Assume again, as in Step 1, that for Plan B, a small plant is built each year.)
Based on your calculations for this Step, do you recommend Plan A or Plan B?

Step 3
Embed flexibility into Plan B; that is, give CompanyX the opportunity to decide not to construct one or two smaller plants. Use this decision rule: at the end of Year 1 (Year 2), another small plant is built only if the demand in Year 1 (Year 2) equalled or exceeded capacity.
Calculate the revised maximum, minimum and expected NPVs for Plant B.
Based on your calculations for this Step, do you recommend Plan A or Plan B?

MY WORDS: actually, when I do it with my partner, even discussing with more classmates, there is no any sured result. Hence, I post it here, and could someone analysis.

Does this problem, in step 1, we should calculate by using the data in Problem Set up ?


(ps, I think this post should be put in here area~~~~
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