NPV and Decision Trees.

1) Your CFO has determined that you should build a new refining facility, either in Bay Town or in Pasadena. The lender will offer different rates for two plans; for the Bay Town facility it offers a rate of 8% and for Pasadena 11%. The costs to build the factories are identical, but different tax and labor circumstances mean that the profit per unit in Pasadena will be $0.85 whereas in Bay Town it will be $0.77. Assuming that the current (year zero) demand for your product is 3 million units, and that the demand will increase by 8% each future period, conduct a Net Present Value decision-making exercise and make a recommendation on which facility to build.

2) Using the previous example (problem #1), conduct a decision tree analysis of this problem assuming that there is instead a 70% chance of demand decreasing by 10% and a 30% chance of demand decreasing by 20% (instead of the steady 5% increase seen in problem 1). Draw the two decision trees and show the process of making this decision. Which offer should you accept, assuming you must accept one of them?

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