Questions:

1. What is the EV for the Large production facility?

2. What is the EV for the Small production facility?

3. What is the EV for further product Development?

4. Which option should be chosen?

5. If results of further product development are favorable, what is the overall project EV at that point?

Radio Schlock is considering the production of a new consumer product with a five-year product lifetime. A new production facility for this upcoming product will be required. Management must decide whether to build a large facility at an estimated cost of $1,000,000 or a smaller facility for an estimated $600,000. Preliminary market research indicates as 65% chance of high demand for the product. High demand for the product is expected to result in a $400,000 per year positive cash flow from a large facility or a $150,000 per year positive cash flow from a smaller facility. Low demand for the product is expected to result in a $50,000 per year positive cash flow from a smaller facility or a $50,000 per year loss from a large facility. A third option has been suggested: delay the decision while further product development is carried out. If the results of this product development are favorable, Marketing estimates there is a 90% chance of high demand for the product. In the event of unfavorable results, Marketing estimates there is a 40% chance of high demand. If Management chooses to pursue this additional product development one year's sales will be lost, although cash flows will otherwise be the same as if the production facility had been built immediately. If the results of the further product development are unfavorable, Management has the option of shelving the project. It is assumed that there is a 50% chance of favorable results from the further product development. Use the total, undiscounted, cash flow in all calculations rather than NPV