A chemical manufacturer is setting up capacity in Europe and North America for the next three years. Annual demand in each market is 2 million kilograms (kg) and is likely to stay at that level. The two choices under consideration are building 4 million units of capacity in North America and building 2 million units of capacity in each of the two locations.

Building two plants will incur an additional one-time cost of

$2 million. The variable cost of production in North America

(for either a large or a small plant) is currently $10/kg, while the cost in Europe is 9 euros/kg. The current exchange rate is 1 euro for US$1.33. Over each of the next three years, the dollar is expected to strengthen by 10 percent with a probability of 0.5 or weaken by 5 percent with a probability of 0.5. Assume a discount factor of 10 percent. What should the chemical manufacturer do? At what initial cost differential from building the two plants will the chemical manufacturer be indifferent between the two options?