The Lumen Lamps Manufacturing Company (LLMC), headquartered in Louisville, Kentucky, is considering opening an assembly plant in a foreign country and transferring a significant portion of its current US-based production to the new plant. After an extensive data collection effort and numerous visits by managers to several possible countries, Grayland has been identified as the most promising country for the new plant. A site near the capital, Curio, appears to be highly suitable, and a new state-of-the art manufacturing facility could be built there very quickly.
The decision on whether to proceed with the move to Grayland will be based on the amount of financial savings in production costs that are projected to be generated over the next 10 years by opening a plant there. However, these savings are surrounded by numerous risks. To keep things simple, the savings levels have been categorized as either high, medium or low. If a move to Grayland takes place, LLMC will evaluate the performance of its investment after the first five years, and if deemed appropriate, will have the option of withdrawing from that country and returning operations to the USA.
Grayland has a relatively new democracy, established after the overthrow of a military dictatorship that had ruled the country for close to twenty years. Unfortunately, poverty level is significant and unemployment rates have recently been as high as 30%. As a result, the current government is keen to attract foreign investors, but it only has a narrow majority in the country’s parliament. Despite the government’s efforts, widespread corruption has persisted, and Grayland is ranked 4th in the World league table of corruption. This issue is one of the main causes of the poor conditions of the country’s road and rail systems, which are now amongst the worst in the region.
If the decision is to relocate to Grayland, there is a risk that a new government will come into power and nationalize all foreign investments. Experts believe that there is only a 0.05 probability of this happening during the first five years, but if it did happen, the loss of assets would cause LLMC to be worse off by $75 million (in present value terms), compared to the returns that would have been generated by continuing manufacturing in the US. Nationalization would also cause LLMC’s association with the country to end immediately. There is also an estimated probability of 0.03 that, within the next five years, the government will impose restrictions on the convertibility of local currency into foreign currency. This would reduce savings by an estimated $43 million (nationalization and currency restrictions can be assumed to be mutually exclusive events).
Insurance can be purchased to cover both of these political risks for the first five years of operations, by paying a total premium which has a present value of $16 million (note that the insurance can only be purchased at the start of the five years). If the company does purchase political risk insurance and nationalization occurs in the first five years, then the insurance will only cover the loss of assets. It is expected that any savings generated before nationalization would be canceled out by the costs of relocation, and so would have present value of $0. If nationalization does not occur, there is a 0.60 probability that in the first five years the investment would generate high savings, with an estimated present value of $85 million. There is also an estimated 0.25 probability that medium savings, with a present value $48 million, would be earned in the first five years, and a 0.15 probability these savings will be low and only amount to $5 million. If no political insurance is purchased, currency restrictions would reduce these savings by the estimated amount given above.
At the end of the first five years the company would have to decide whether to continue to operate the plant in Grayland for another five years, or whether to transfer operations back to the US. However, this decision will only be considered if the savings in the first five years have been low. If LLMC withdraws from Grayland, then the plant will be sold for a return with an estimated present value of $10 million. If LLMC decides to continue operating in Grayland for another five years, the risk of nationalization during this period is difficult to estimate but will be between 0.10 and 0.20. However, the risk of restrictions on the convertibility of local currency is estimated to be the same as that in the first five years.
The total insurance premium to cover these risks for the second five years would have a present value of $12.8 million. If insurance is purchased and nationalization occurs in the second five years, then it is the assumed that gross savings made before nationalization will again be cancelled out by the costs arising from the disruption. For simplicity, the present values of other costs and savings occurring under each set of conditions in the second five years are assumed to be the same as those in the first five years, with a 20% reduction to account for the time value of money. However, the probabilities of high, medium, and low returns in the second five-year period will be dependent on the level of returns achieved in the first five years, as shown in the table below.
Second five years
First five years
For example, if savings in the first five years have been high, then: there is a 0.60 probability that high savings will be maintained in the next five years, a 0.30 probability that only medium savings will be generated, and a 0.10 probability that savings will be low. The other two rows in the table can be interpreted in a similar manner. It can be assumed that if the company stays in Grayland for ten years, it will sell the plant at the end of this period and generate extra returns with a present value of $6 million.
Part A: Provide a graphical representation of the decision problem using influence diagrams. You can build one diagram, or more than one. If you build more than one, make sure you describe how are your multiple diagrams related to each other.
Part B. Using the Decision Analysis methods, build a model that addresses the decision problem faced by LLMC, and recommend the policy that the company should pursue. Keep in mind that:
- This is a large and complex decision problem, and you may need to break it into different parts to facilitate your analysis.
- You need to clearly state all your assumptions, identify them as such, and explain your logic.
- You must include all your calculations to get full credit.
Part C. Discuss the strengths and limitations of your analysis in terms of the usefulness of the insights that it could offer to LLMC’s managers.
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