Case-4

A chemical manufacturer sets up capacity in Europe and North America for the next year. The current annual demand in each market is 10,000 units. The next year, the demand is expected to decrease by 10 percent (10,000-0.1*10,000 = 9,000 units) with a probability of 0.7 or to increase by 20 percent (10,000 + 0.2*10,000 = 12,000 units) with a probability of 0.3.

The current exchange rate is 1 euro for the U.S. $1.20. The following year, the exchange rate is expected to increase by 5 percent (exchange rate 1 euro for the U.S. $ 1.20*(1.05) = $1.26) with a probability of 0.6 or to decrease by 10 percent (exchange rate 1 euro for the U.S. $ 1.20*(0.9) = $1.08) with a probability of 0.4.

The two choices under consideration are building 12,000 units of capacity in North America (Option 1) or building 6,000 units in each of these two locations (Option 2). The variable cost of production in North America (for either a large or a small plant) is currently $2.4/unit, whereas the cost in Europe is 2 euro/unit. The current exchange rate is 1 euro for the U.S. $1.20.

The one-time construction costs to build a 12,000 unit capacity factory in North America is $ 40,000, a 6,000 unit capacity factory in North America is $25,000, and a 6,000 unit capacity plant in Europe is 10,000 euro.

1. Draw a decision tree. (6 points)

2. Calculate option 1 and option 2's total cost (Round your answer to three decimal places) (17 points)

Option 1: Total Cost =

	Year 0	Year 1
North America	$64,000

Option 2: Total Cost =

	Year 0	Year 1
North America	$49,000
Europe	30,000 Eur or $36,000

3. What is your recommendation? Why? (4 points)