Question: The company Realoption needs to accommodate additional demand for its product, but the amount of the additional demand is uncertain. Realoption can either build a small new plant or a big new plant. If the additional demand is not significantly large, the small plant would be sufficient. However if the additional demand is large, a small plant may not be able to meet all the demand, which implies that to that extent the company will be unable to realize profits. After observing the demand trend for a year, Realoption may choose to expand the small plant if necessary. However if Realoption chooses to build a large new plant, high costs may result in loss if the demand is not large. On the other hand a big plant will be better able to meet high levels of demand. Note that it is not possible to shrink the size of the plant.

A. Draw a decision tree diagram to analyze if Realoption should build a small or a big new plant.

B. List all the data that needs to be collected for the analysis. Describe a few data collection methods. The ones we talked about this week are:

i. Standard deviation as a measure of risk

ii. Risk Premium = Expected Value - Certainty Equivalent

iii. Desirability and Utility Curves