IE5003

NATIONAL UNIVERSITY OF SINGAPORE FACULTY OF ENGINEERING EXAMINATION FOR Semester II: 2011-12

IE5003 COST ANALYSIS & ENGINEERING ECONOMY April 2012 Time allowed: 2 Hours

INSTRUCTIONS TO CANDIDATES:

1. This examination paper contains THREE (3) questions and comprises SEVEN (7) printed pages. 2. Answer ALL questions. 3. The total mark for the paper is 60. 4. This is an OPEN BOOK examination. 5. Programmable calculators are NOT allowed for this examination. 6. Compounding tables provided can be used.

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IE5003 Question 1: Single Project Evaluation (25 marks) You are an engineer at a prestigious telecommunication firm. Your division is involved in the design of a satellite-based infrastructure system supporting worldwide cell-phone communications. As suggested by de Weck et al. (2004) 1 , the number of channels Nch required to satisfy user demand is defined as:
N ch N user Auser 365 Us 24 60 12

where Nuser is the expected number of subscriber, Auser is the average individual activity level (in minute), and Us is the global system utilization. Management expects Nuser = 2 million in t = 2 years, Auser = 125 min./month, and Us 0.1. It plans to charge $3/minute of service. The variable cost of operating one channel is $3,500 annually (only if used), annual fixed cost is $5 million, investment cost at t = 0 is $50 million, and demand is expected to increase linearly by 1 million user by End of Year (EoY) t = 1 to reach 2 million in EoY t = 2. The effective tax rate is 17%. Assuming the design will be deployed for full capacity at t = 0 (although not all channels will be used in year 1), the company expected the following Before-Tax Cash Flows (BTCF):

End of Year (EoY) User demand (thousand) Required channel capacity (thousand) Channel capacity installed (thousand) Revenues (thousand $) Variable cost (thousand $) Fixed cost (thousand $) Investment cost (thousand $) Salvage value (thousand $) Before Tax Cash Flow (BTCF) (thousand $)

0 1 2 0 1,000 2,000 0 30 60 0 60 60 0 135,000 270,000 0 105,000 210,000 0 5,000 5,000 50,000 0 0 0 0 0 -50,000 25,000 55,000

a) Management is considering funding 60% of the initial investment cost by issuing bonds. The nominal interest rate offered to investors is 6% paid semi-annually over the 2 years of the project. How much should management put aside every year in a sinking fund earning 4% semi-annually to cover retirement of the bond at the end of the project (2 marks)? What is the total cost of debt every year, considering in addition interests payments (3 marks)? (5 marks total)

de Weck, O. L., de Neufville, R., & Chaize, M. (2004). Staged Deployment of Communications Satellite Constellations in Low Earth Orbit. Journal of Aerospace Computing, Information, and Communication, 1, 119136.

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IE5003 b) The stock of a comparable company currently offers investors a 5% premium over the risk free rate. Such stock has = 2.0 compared to the S&P 500 index. Assuming a risk-free rate of 3%, what rate of return should management offer to potential shareholders? (2 marks total)

c) The management team wants to determine the effective annual Weighted Average Cost of Capital (WACC) for this project. Calculate the WACC (2 marks), and also explain why this WACC should be used as the Minimum Attractive Rate of Return (MARR) to evaluate this project (1 mark). (3 marks total) Note: round your answer to the nearest percentage integer for your calculations below (e.g. 10.3% 10%; 10.5% 11%)

d) Management asks you whether this project is worth undertaking. You go ahead and calculate the Present Worth (PW), Future Worth (FW), and Annual Worth (AW) of the project (4 marks). You set out to calculate these using the After Tax Cash Flow (ATCF) approach, and ignore the costs of debt in the ATCF. You assume straight-line depreciation of the initial investment cost, and no salvage value (SV) at the end of year 2. Should the project be undertaken (1 mark)? (5 marks total)

e) Management typically relies on the Internal Rate of Return (IRR) for their decisionmaking. They ask you to calculate it using the ATCF above (4 marks). Also, they ask you to determine whether this project is worth undertaking (1 mark). (5 marks total)

f) After determining the IRR, you feel pressed to explain to your colleagues at least five problems with the IRR valuation metric. (5 marks total)

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IE5003 Question 2: Selection of Alternatives and Capital Budgeting (15 marks) Management recognizes that expectations in user demands will affect the required capacity (in terms of number of channels), and ultimately the value of the system. They are not sure, however, how to determine whether higher capacity levels are worth the incremental investment cost. Your team provides an assessment for three possible capacity levels, optimized for the three user demand scenarios shown below: Alternative A1 30 channels A2 60 channels A3 90 channels End of Year (EoY) User demand low-level (thousand) ATCF low-level capacity (thousand $) User demand mid-level (thousand) ATCF mid-level capacity (thousand $) User demand high-level (thousand) ATCF high-level capacity (thousand $) 0 0 -25,000 0 1 500 10,425 1,000 2 1,000 22,875 2,000 0 4,264 2 (SV) PW

0 -75,000

1,500 39,575

3,000 76,925 0 27,594

a) First, insert the ATCF and PW values corresponding to the mid-level demand scenario you calculated in Question 1. Assume the same MARR as above for Question 1. Using incremental investment analysis on PW, what alternative would you recommend (i.e. A1: 30 channels, A2: 60 channels, or A3: 90 channels)? (5 marks total)

b) Your colleague hears that management is also considering investing in two mutually exclusive land-based cell phone technologies. These are referred insightfully as projects B1 and B2, with annual cash flows shown below. Anxious to know what project could possibly compete with yours, you evaluate these two alternatives to determine which one is the most promising. You expect these projects to have the same risk and return profiles as above i.e. assume the same MARR as for part a). (5 marks total) Alternative B1 B2 40,000 60,000 30,000 25,000 0 0 2 3

Investment cost (thousand $) ATCF (thousand $) Salvage value (thousand $) Useful life (years)

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IE5003 c) To your dismay, your colleague mentions there might be another project in satellite-based technology competing directly with yours. The project has three independent alternatives, referred as C1, C2, and C3, with investment costs and PW shown below. Your colleague mentions that B1 and B2 actually depend on the acceptance of one of your project alternatives: A2 or A3. You decide to solve this problem using linear programming, assuming the same MARR as above, and a maximum budget of $150 million. You setup the optimizations problem so your colleague can solve it using her favorite computer software. (5 marks total) Alternative C1 C2 C3 40,000 60,000 60,000 20,000 35,000 50,000

Investment cost (thousand $) PW (thousand $)

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IE5003 Question 3: Project Evaluation Under Uncertainty (20 marks) The system analyzed in Question 1 has capacity for 60 channels, suited for mid-level demand (referred as baseline system). You know that demand uncertainty will affect the economic performance of the system. In order to make your case, you need to show graphically the impact of uncertainty, and give hard numbers to the management team. You also want to show that flexibility in the engineering design can help you deal pro-actively with this uncertainty. You start by obtaining the PW of ATCF for the baseline system for each demand scenario: Demand Scenario Low-level Mid-level High-level Baseline system PW (thousand $) -16,946 27,457

a) First insert in the table the PW you have calculated for the system accommodating midlevel demand and capacity. Then construct a tornado diagram to show graphically the sensitivity of PW to changes in the demand. (5 marks total)

b) To demonstrate further the impact of uncertainty on value, you setup a decision tree for the baseline system. Because you are under complete uncertainty, you assume equal likelihood for each demand scenario (Hint: no calculation is needed here). (5 marks total)

c) One design dealing with uncertainty starts initially with capacity for low-level demand (i.e. 30 channels). It has the ability to expand at the end of year 1 to the capacity expected at EoY 2. This strategy will reduce the impact of a less profitable scenario where low-level demand arises, while giving the company access to profits from mid-level and high-level demand scenarios. You setup a decision tree for this flexible system, using the PW values shown below. For example, if capacity is deployed for low-level demand at t = 0 and low-level demand is observed at EoY t = 1, then capacity should stay same, leading to PW = $4,264 (thousand). If mid-level or high-level demand is observed and capacity stays same (i.e. no expansion), PW = $15,792 (thousand). On the other hand, if mid-level demand is observed at t = 1 and capacity expansion (i.e. expand) occurs, PW = $37,140. If high-level demand is observed at t = 1 and capacity expansion occurs, PW = $58,488. (Hint: no calculation is needed here) (5 marks total) Flexible system Stay same Expand PW (thousand $) PW (thousand $) 4,264 N/A 15,792 37,140 15,792 58,488

Demand Scenario Low-level Mid-level High-level

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IE5003 d) You now set out to quantify the value of flexibility. For the inflexible and flexible alternatives, you calculate the average or expected PW (E[PW]), the minimum PW, and the maximum PW, assuming equal likelihood of all demand scenarios. You compare the two alternatives based on these evaluation metrics, and present your results by filling out the table below (3 marks). What is the maximum you should be willing to pay to acquire the flexibility (2 marks)? (5 marks total) Metric E[PW] (thousand $) Minimum PW (thousand $) Maximum PW (thousand $) Baseline Flexible Best?

END OF PAPER

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