Assuming that the management of NMC wish to maximize expected net returns, determine the optimal policy which they should pursue.
The Northern Manufacturing Company (NMC) is considering extending its operations by opening a manufacturing plant in an overseas country. Two countries are being considered, Slohemia and Tundrastan, but resource constraints mean that only one of these countries can be selected. The decision will largely be based on the level of sales of NMC’s products which can be achieved over the next 5 years in the host country. For simplicity, these sales have been categorized as either high or low. If Slohemia is selected there is estimated to be a 0.3 probability that a new government will come into power within the next 5 years and nationalize all foreign investments. This would lead to losses with an estimated present value of $10 million being incurred by NMC. If nationalization does not take place it is thought that there is a 0.7 probability of high sales being achieved. These would generate net returns having an estimated present value of $95 million. Low sales would lead to net returns with a present value of $15 million. If Tundrastan is selected the chances of achieving high sales will depend on whether a local company sets up in competition with NMC. It is estimated that there is an 80% chance of this happening. However, if there is no competition there is thought to be a 0.9 probability of high sales occurring. These would generate net returns with an estimated present value of $90 million. Low sales would lead to net returns with a present value of $10 million. If NMC does find itself facing competition in Tundrastan, it would first have to decide whether to attempt to buy out the competitor. This would be expensive. Indeed it is estimated that it would reduce net returns, by $20 million, irrespective of whether it was successful. The chances of a success are estimated to be only 75%, but a successful buyout would lead to market conditions identical to those involving no competition. If a decision was made not to attempt the buyout, or if the buyout failed, NMC would then have to decide whether to lower its prices to undercut the competitor. This would reduce net returns by around $30 million but its effect would be to increase the chances of high sales from 0.5 to 0.8.
(a) Assuming that the management of NMC wish to maximize expected net returns, determine the optimal policy which they should pursue.
(b) Discuss the limitations of the analysis which you applied in part (a).
(c) The estimate that there is a 30% chance that a new government in Slohemia will come to power and nationalize all foreign assets has been disputed by a number of NMC’s managers. Many think that the probability has been overestimated. Perform a sensitivity analysis on this estimate and interpret your result.
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