Decision Analysis for Managers

Assignment: Case Study Analysis - AMECO Relocation Decision Problem

Introduction to the case study

This case study is based on a real case; of course, anonymized for obvious reasons. The case study considers the problem of Agricultural Machinery Exporters Company (AMECO), a company considering relocating its manufacturing facilities from the UK to an overseas country. In making its decision, the company needs to take into account a number of political risks that it will face if it decides to go ahead with the relocation. The decision problem is made complex by the large number of combinations of possible events that can occur and the challenges that arise from the need to structure the problem in a way which makes analysis of the problem tractable. Note that all of the monetary values presented in the case have already been expressed as present values to avoid the additional complication of applying discounted cash flow analysis to the data. Carefully read the case study and answer the question that follow.

AMECO Relocation Decision Problem

Agricultural Machinery Exporters Company (AMECO), which has its headquarters in the UK, is considering opening a manufacturing plant in an overseas country and transferring much of its current UK-based production to the new plant. After extensive data collection and visits by managers to a number of possible countries, Almeria has been identified as the most promising country for a new plant. A site near the capital, Lasia, appears to be highly suitable and a new state-of-the art manufacturing facility could be constructed there very quickly.

The decision on whether to go ahead with the move to Almeria will be based on the level of monetary savings in production costs that it is hoped would be generated over the next 10 years by opening a plant there. However, there are a number of risks associated with these savings and, for simplicity, the level of savings is categorised as either high, medium or low. If a move to Almeria does go ahead, AMECO will review the success of its investment after the first five years and will have the option of withdrawing from that country and returning operations to the UK if this appears to be appropriate.

Almeria has a relatively new democracy which was created following the overthrow of a military dictatorship that had ruled the country for nearly thirty years. However, there is considerable poverty and unemployment rates have recently been as high as 38%. The current government is therefore keen to attract foreign investors, but it only has a narrow majority in the country's parliament. Despite the efforts of the government, widespread corruption has persisted and Almeria is ranked 5th in the World league table of corruption. Corruption is partly responsible for the neglect of the country's road and rail systems which are now amongst the worst in the region.

If a decision is made to relocate to Almeria there is a risk that a new government will come into power and nationalize all foreign investments. There is thought to be only a 0.05 probability of this happening during the first five years, but if it did occur, the loss of assets would cause AMECO 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 UK. Nationalization would also cause AMECO's association with the country to end immediately.

Insurance can be purchased to cover the political risk of nationalization 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 take place it is thought that there is a 0.6 probability that in the first five years the investment would generate high savings having 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.

At the end of the first five years the company would have to decide whether to continue to operate the plant in Almeria for another five years or whether to transfer operations back to the UK. However, this decision will only be considered if the savings in the first five years have been low. If a decision to withdraw is made then the plant will be sold for a return with an estimated present value of $10 million. If AMECO decide to continue operations in Almeria for a further five years the risk of nationalization during this period is estimated to be 0.15.

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 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 5 years, with a 20% reduction to take into account the time value of money. However, it is thought that 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

For example, the table above shows that if savings in the first five years have been high then there is a 0.70 probability that high savings will be maintained in the next five years, a 0.2 probability that only medium savings will be generated and a 0.10 probability that savings will be low. The other two rows can be interpreted in a similar manner. It can be assumed that if the company stays in Almeria for ten years, it will sell the plant at the end of this period and hence generate extra returns with a present value of $6 million.

Carefully study the AMECO Relocation case study above and address the following questions related to the case study.

(1) Construct decision tree(s) to represent AMECO decision problem

More guidance notes on applying decision tree analysis on the AMECO decision problem

A decision tree model can be used to analyze this decision. Because of the size of the problem, it is suggested that you break down the decision trees into four sub-trees as follows:

Decision Tree 1: Depicts the decision that face the company in planning for the first 5 years of potential operation in Almeria

Decision Tree 2: Depicts the decision for second 5 years if savings in the first 5 years are high Decision Tree 3: Depicts the decision for second 5 years if savings in the first 5 years are
medium

Decision Tree 4: Depicts the decision for second 5 years if savings in the first 5 years are low Decision trees 2, 3 and 4 are best constructed first so that the optimal expected savings that they indicate can be ‘rolled back' and added to the savings for the first five years in decision tree 1.

(2) Using your decision tree (from 1 above) and the folding back the tree procedure, calculate the expected monetary value (EMV) of the two options at the root of AMECO decision problem i.e.

(A) move operations to Almeria or (B) DO NOT move operations to Almeria. Clearly shows your workings. (100 words)

(3) Based on the EMV criterion, discuss the alternatives or strategy AMECO should pursue in order to maximize their expected savings. For example (a) should they transfer operations to Almeria?; (b) If they move to Almeria, should they buy political risk insurance for the first five years?; (b) should they continue operations after the first five years? (c) if they continue operations for the second five years, should they buy political risk insurance? etc. Explain/justify or provide a reasoning for your answers. (500 words)

(4) It may be expected that the EMV and hence your recommended strategy for AMECO obtained in in questions 2 and 3 above critically depends on uncertain variables or chance events that are not within the control of the decision maker. Therefore, conduct a sensitivity analysis on your recommended strategy for AMECO, supported by constructing a one-way sensitivity graph. Briefly explain the implications of your results to AMECO's decision problem.
(200 Words)

(5) Briefly discuss at least one example from your reading of the academic literature (peer reviewed journal articles) in which decision tree analysis have similarly been applied to structure and solve a decision problem. (focus on the literature relevant to your master's degree subject area) (200 Words)