A manager is trying to decide whether to buy one machine or two. If only one is

Question

A manager is trying to decide whether to buy one machine or two. If only one is purchased and demand proves to be excessive, the second machine can be purchased later. Some sales will be lost, however, because the lead time for producing this type of machine is six months. In addition, the cost per machine will be lower if both are purchased at the same time. The probability of low demand is estimated to be 0.20. The after-tax net present value of the benefits from purchasing the two machines together is $90,000 if demand is low and $180,000 if demand is high. If one machine is purchased and demand is low, the net present value is $120,000. If demand is high, the manager has three options. Doing nothing has a net present value of $110,000; subcontracting, $140,000; and buying the second machine, $120,000 r a. Choose the correct decision tree for this problem. Note that each payoff is given in thousands of dollars

Explanation / Answer

2 machines

Pay off: 110,000, do nothing.

Eventually, demand is susceptible to increase in the future but the key benefit is to buy both the machines together with a cost advantage and the excess amount will be substituted with higher demands met, rather than losing sales.

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