Melony, pg. 1
MELONY CORPORATION
You are the CFO of Melony Corporation. Melony is a small, but successful and growing,
producer of optical equipment. Five expansion proposals for exploiting various
opportunities are on your desk. You will perform a detailed financial analysis of each
proposal (cash flow projections, net present value analysis, etc.). Your firm has the
resources to pursue any combination of the five opportunities. At present, Melony has
two production plants, Plant I and Plant II. It has no separate distribution facility; output
is transported directly from each of the two plants directly. Furthermore, the research
department is now housed in Plant I; proposal E below involves building a separate
research facility.
The five opportunities to be analyzed have the following characteristics.
A: Facility upgrade at Plant I (the sole purpose of Plant I is to produce products that
are used as inputs by Plant II)
B:
Distribution facility that will expedite shipments from Plant I to Plant II; this
facility will raise output at Plant II and increase the need for greater output at Plant
I. This distribution facility can be constructed only if the facility upgrade at Plant
I (A) is made.
C: Additional Computer system to enable an output increase at Plant II; however,
this output increase can only occur if A is done (i.e., only if there is the facility
upgrade at Plant I)
D: Research Facility X for the development of new products.
E:
Employment of a new research team for Research Facility X. The employment
of the new research team (E) cannot occur unless Research Facility X is
constructed (D).
Other than those identified above, there are no significant economic interdependencies
between opportunities A, B, C, D and E.
(a)
Define an “independent set.” In performing an efficient analysis with no capital
budget constraint, how should A, B, C, D and E be divided into projects?
(b)
What is the efficient procedure that Melony could follow in evaluating A, B, C, D
and E? State the steps clearly (the first step is to identify the relevant opportunities
to evaluate, which we have already done). You are very cognizant of the fact that
independent set evaluation is costly and you want to approach this problem in the
most cost-effective way.
Melony, pg. 2
Solution
(a)
An independent set is a set of opportunities that are economically independent of all
opportunities not within that set. It follows from the information in the problem
that A, B and C are economically interdependent (but economically independent of
D and E), and that D and E are economically dependent (but economically
independent of A, B and C). Let A, B and C be independent set I and let D and E
be independent set II. The interdependency links are shown in the figure below.
A
B
C
D
E
(b)
The proper procedure is to:
1.
2.
3
List all opportunities to be analyzed
Divide the opportunities into the maximum number of independent sets
possible
For each independent set, adopt the combination of opportunities
(alternative) that has the highest net present value (where one alternative
is to adopt none of the opportunities within the independent set)
Let’s identify all the potential combinations of opportunities in Projects I and II
ignoring the nature of interdependencies among the opportunities; we will then
eliminate combinations that are not feasible.
Independent set I combinations:
A
B
C
A and B
A and C
B and C
A, B and C
None (none of A, B or C)
Independent set II combinations:
D
E
D and E
None (neither D nor E)
Melony, pg. 3
Now let’s factor in what we know about the interdependencies. For independent set
I, notice that B cannot occur without A; therefore, any alternative in independent set
I that involves opportunity B without opportunity A is irrelevant (so delete B alone
and delete the combination of B and C). Furthermore, opportunity C produces no
benefits without opportunity A, and therefore any alternative in independent set I
that involves C without A is irrelevant (this means that C alone and the
combination of B and C are irrelevant). Thus, we have pruned away (as not worth
considering) some of the independent set I combinations listed above. We
conclude that the alternatives within independent set I that are relevant (i.e., that
might be adopted) are:
A
A and B
A and C
A, B and C
None (none of A, B or C)
Now lets look at independent set II. The information provided indicates that E
cannot be done without D. Therefore, delete from consideration alternative E
alone. It follows that the alternatives within independent set II that are relevant
(i.e., that might be adopted) are:
D
D and E
None (neither D nor E)