GSM NETWORK CAPACITY INVESTMENT UNDER UNCERTAIN DEMAND IN CHINA

Sad Boukendour Universit du Qubec en Outaouais Box Office 1250, station Hull Gatineau (Qubec) Canada J8X 3X7 E-Mail : said.boukendour@uqo.ca Jiye Liao Carleton University 1125, Colonel By Drive Ottawa (Ontario) Canada K1S 5b6 E-Mail: jliao@connect.carleton.ca Abstract: This paper applies a real options approach for GSM network capacity planning under uncertainty and irreversibility. We assume a stochastic demand that evolves following a Wiener process whereas we assume that unit sale price, cost of investment, operating and maintenance costs remain fixed for a period of a year. Data were gathered from one citys network of China Mobile, the biggest GSM operator in the world. A capacity planning is built on the basis of these data. The main contribution of this research is to apply a real options approach where traditionally rule of thumb prevails. Hence, it provides a systematic and practical tool that can guide decision making in GSM capacity upgrading. Keywords: GSM network capacity, investment, irreversibility, uncertainty, real options

Introduction
Wireless communication service is the fastest developing telecommunication service in the last several years. It impacts personal and business communications and trends to replace traditional fixed line telephone service. Among several wireless technologies, the GSM has the biggest wireless service market share, which is more than 73%. From the report of GSM Association in Nov, 3, 2003, more than 900M subscribers and more than 600 operators are using GSM system in 206 countries. In china, there are 4.5M new subscribers every month recently, or 3.8% per month. By conservatively predicted, the total subscribers will be beyond 1B in early 2004. With 15.5% users of global GSM subscribers, China Mobile is the biggest GSM and wireless operator in the world and subscribers number keeps growing steadily. For reasons of competition and regulation, the price of wireless service and average revenue per user are dropping continually. However, the deceasing service price and more wireless application not only attract new customers to subscribe, but also increase registered customers consumption. While the market demand is increasing, GSM service providers should invest in capacity to satisfy their customers. They often face a dilemma of under capacity investment, which will causes poor performance and loss of customers and over capacity, which will causes waste of resources. Operators consider how quality affects the financial success though capacity and how to invest in capacity more clearly to improve financial success and customers satisfaction. When investment is irreversible and demand is uncertain, firms cannot disinvest, without incurring costs, should market conditions change adversely. Therefore, delaying the decision to invest and waiting for new information could be valuable; although there are occasions in which competition requires to invest quickly. This aspect of investment has been neglected by the traditional NPV rule that dictates to invest when the discounted cash flow of a project exceeds its expenditure of capital. Following the seminal work of Black and Scholes (1973) and Merton (1973), Myers (1977) first introduced the real options approach, which views an investment decision as a call option on a project. The value of waiting to invest has been calculated by McDonald and Siegel (1985). Their calculations and those made by Majd and Pindyck (1987) show that the value of the opportunity to delay an investment is large when there are irreversibility and uncertainty. Several researches have adopted similar approach to value the investments in natural resources (Paddock et al. 1987), in real estate (Titman, 1985), in research and development and technological innovations (Grenadier 1997, Lint and Pennings, 1998). In the domain of telecommunications, the optimal decision problem of building new capacity in the presence of stochastic demand for services is studied by Halluin et al.(2002). They notice that sometimes it is optimal to wait until the maximum capacity of a line is nearly reached before upgrading directly to the line with the highest line known transmission rate. This article deals with the issue of capacity planning and attempts to determine when and how much to invest in capacity in order to meet a stochastic demand and to ensure a 2

maximum profit for the company. The article is organized as follows. Firstly, we discuss the real option approach of capacity choice, then we describe data and methodology, then we outlines a capacity planning and finally we conclude with the limitations of this research and further developments.

Real option approach of capacity choice

The decision to invest involves exercising or killing of an option to invest at any time in the future. This lost option value must be included as a part of the cost of an investment. Thus, an analysis of investment must compare on the hand the expected discounted cash flow resulting from the project, and on the other hand the total cost of the investment that includes the expenditure of capital plus the lost option value. Similarly, Pindyck (1988) determines the firm's optimal capacity choice by equalizing the net present value of the expected cash flow from a marginal unit of capacity with the total cost of that unit. This total cost includes the purchase and installation cost, plus the opportunity cost of exercising the option to buy the unit. Let be the value of current demand that is log normally distributed with a mean and variance 2 that grow with the time horizon. The firms cost and production constraints are as follows. Each unit of capital brought at a fixed price k provides the capacity to produce one unit per period, which it sells at a price t, with operating cost (2 +c2)K+c1 and K is the current capacity. The production can be shut down temporarily and costless should the price falls below the operating cost. This gives the firm an infinite number of options to produce one unit of output with exercise price equal to production or operating cost. For simplicity, he also assumes that new capacity can be installed instantly and capital in place does not depreciate. To use contingent claim valuation methods, one more assumption is added. That is stochastic changes in demand are spanned by existing assets. In other words, there is an asset or dynamic portfolio of assets whose price is perfectly correlated with . Let be the assets or portfolios expected return, the firms expected flow of profits resulting from one marginal unit is discounted at a rate = >0.This assumption holds for most commodities, which are usually traded on both spot and future market but it does not holds in many other cases. The decision rule to invest in a marginal unit of capacity is determined by solving for * the following equation (1) where * is the critical value of demand at or above which it is optimal to purchase the marginal unit of capacity. In other words, if and K are such that > (K), the firm should add capacity, increasing K until rises to . Equivalently, in terms of K(), the firms optimal capacity is given by solving equation (2) for K*. (1)

b2 ( 1 2 ) ( 1) (2 + c 2 ) K + c1 ( *) 2 + 1 k =0 * r 1 1

(2)

[(2 + c2 ) K * +c1 ] + ( 1 1) k = 0 r 1 (r ) 2 [(2 + c2 ) K * +c1 ]1 2 r 1 r1

With:

1 = 2 =
b1 =

r 2 2

+ 1 2 ( r 2 2) + 2 r 2

12

>1

r 2 2

1 2 ( r 2 2) + 2 r 2

12

<0

r 2 (r ) [(2 + c2 ) K + c1 ]1 1 > 0 r ( 1 2 ) r 1 (r ) [(2 + c2 ) K + c1 ]12 > 0 r ( 1 2 )

b2 =

and r : risk free interest rate

Data and methodology

Technically, GSM networks performance is measured by four main variables: Total network traffic is measured by Erlang unit corresponding to one user holding for one hour, Call requests, measured by times that one user dials up one time, Network congestion, due to capacity shortage, is measured by block rate i.e. failed dials divided by call requests, Drop calls are unexpected disconnections when user is holding.

We have gathered daily data about all these variables from June 2003 to October 2003 from one citys network of China Mobile. We have removed anomalous drops and statutory holidays. To estimate daily demand, we totalize network traffic with network congestion because we assume that network congestion represents the unsatisfied demand whereas the network traffic is the satisfied demand. Graph 1 below shows the evolution of the total demand from a day to day. To estimate the discounted rate for profits resulting from a marginal unit of capacity, it requires to span the stochastic demand by an existing asset traded on future market. A such market does not exist in telecommunications industry. As a proxy, we can build a synthetic portfolio of shares and bonds traded in the Hong Kong Stock Exchange such that this portfolio is perfectly correlated with the stochastic demand. Nonetheless, we must underline that the analogy between financial options and real options must be varied. In case of financial options, the purpose of the assessment is to determine the price to which the option should be traded while the purpose of the real options approach is to help the decision maker to choose the best alternative. Therefore, for simplicity and practicability, we assume that both profits and operating cost are discounted at the same

rate so that =r. According to the companys financial report for year 2003 , the interest rate is 6%. From the same report, the average sale price of one Erlang unit is 30 RMB. The operating costs are made up of labor, energy and maintenance costs. The operating cost per channel is estimated to be 2.4RMB per hour and the cost of investment in one channel is approximately 10 000RMB. Although the prices and the operating costs are changing over a long period of time, we assume that they contractually remain fixed within a period of one year.
Graph 1. Demand of day T/Demand of day T-1

1,2

0,8

0,6

0,4

0,2

0 1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 Days

Capacity planning
The issue is to determine when and how much to invest in capacity. From GSM network operation experience, we assume that the network capacity is only upgraded at weekends. On the basis of data gathered from China Mobile, we compute the optimal capacity to add every week (see Table 1). By capacity, we mean the total traffic in Erlang that channels should support. By analogy with a road, we designate the traffic of vehicles that the road can support but not the number of lanes. Starting with zero capacity at week 1, we compute the average demand in Erlang for this week, that is 17840. Using equation (1) we compute numerically the critical value of the demand at or above which it is optimal to invest that is =2 Erlang. This is the trigger that indicates when it is optimal to add capacity. Since the total demand exceeds the trigger, the firm should add capacity until () rises to the total demand (). To determine the optimal capacity (K*) to install, we numerically solve equation (2) and we get approximately 29730 Erlang. Then the current capacity rises from 0 to 29 730 for the week 2 and we also observe

that the trigger () rises to 17840 Erlang. The average demand of week 2 is 17344 Erlang. Since this is below the trigger, the firm should not invest. Using again equation (2), the optimal capacity becomes 28903 Erlang. This corroborates that the firm should not invest. But, since there is irreversibility, the firm cannot disinvest and the current capacity remains equal to 29730 Erlang. At the end of week 3, the average demand is 17930 Erlang, which is below the current capacity of 29730 Erlang. From equation (1), the trigger remains equal to 17840 Erlang. Since the average demand (17930) is greater than the trigger (178400), the firm should increases its capacity until it rises to the optimal capacity, which is 29880 Erlang. Table 1 below displays the results from June to October, 2003.

Table 1. Capacity planning

Week Start Date Finish Date Initial capacity Average demand Trigger Optimal capacity Decision Increment New capacity

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

2003-06-02 2003-06-09 2003-06-16 2003-06-23 2003-06-30 2003-07-07 2003-07-14 2003-07-21 2003-07-28 2003-08-04 2003-08-11 2003-08-18 2003-08-25 2003-09-01 2003-09-08 2003-09-15 2003-09-23 2003-09-30 2003-10-07 2003-10-14 2003-10-21

2003-06-06 2003-06-13 2003-06-20 2003-06-27 2003-07-04 2003-07-11 2003-07-18 2003-07-25 2003-08-01 2003-08-08 2003-08-15 2003-08-22 2003-08-29 2003-09-05 2003-09-12 2003-09-19 2003-09-27 2003-10-04 2003-10-11 2003-10-18 2003-10-25

0 29730 29730 29880 31822 32258 32258 32258 32258 32258 32258 32258 32258 32258 32294 32294 32377 33600 33600 33600 35057

17840 17344 17930 19095 19357 18702 18331 18621 18366 18368 18708 19038 19936 19378 19156 19428 20162 20070 19379 21036 19962

2 17840 17840 17930 19095 19357 19357 19357 19357 19357 19357 19357 19357 19357 19378 19378 19428 20162 20162 20162 21036

29730 28903 29880 31822 32258 31166 30549 31032 30606 30610 31176 31727 31727 32294 31923 32377 33600 33447 32294 35057 33266

Invest Wait Invest Wait Invest Wait Wait Wait Wait Wait Wait Wait Wait Invest Wait Invest Invest Wait Wait Invest Wait

29730 0 150 1942 436 0 0 0 0 0 0 0 0 36 0 83 1223 0 0 1457 0

29730 29730 29880 31822 32258 32258 32258 32258 32258 32258 32258 32258 32258 32294 32294 32377 33600 33600 33600 35057 35057

Graph 2 below illustrates the optimal investment in capacity. In the top of the Graph, we observe how current capacity and optimal capacity evolve. The gap between them is due to the irreversibility of the investment. Should the investment be reversible, the current capacity will converge to the optimal capacity. Similarly, in the bottom of the Graph, the trigger indicates at what level of the demand it is optimal to add capacity and how much. Uncertainty explains the gap between capacity and demand, which evolves stochastically. This gives options to produce services should the demand grow up. The higher the uncertainty and the higher the profit per unit, the higher the gap.

Fig 2. Evolution of dem and and capacity

40000

35000

Demand and capacity

30000

25000

20000

15000

Initial capacity
10000

Optimal capacity Average demand Trigger

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 2 21

5000

Weeks

Conclusion
The main issue of GSM capacity investment is to determine when, how much and in which base station (where) to add capacity. The real option approach helps to determine when and how much to invest by comparing the profits resulting from additional capacity on one hand and the cost of investment and the value of keeping alive the option to invest at any time in the future on the other hand. This is made by adopting many restrictive assumptions that do not correspond to the reality of business. In further developments we expect to relax some of these assumptions keeping in mind that from a practical point of view, a model is useful only if it is understandable, reliable, and easy to use. Once the total capacity to install is fixed, the next step is determining the optimal locations according to the demand recorded in the past in every place. This decision affects considerably the global efficiency of the network because if it exists congestion in some places and excess of capacity in other places cannot be used. This problem will hopefully be solved by technological innovations, the creation of new services and the decrease of the costs of facilities.

References
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