Final_ISE460_F06_sol

Final_ISE460_F06_sol - ISE 460 FINAL 12/07/06 Solution Fall...

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ISE 460 Fall 2006 FINAL 12/07/06 Solution Problem No. 1 A project requires substantial working capital. Inventory and deferred payments from customers are the major contributors. The length of the project is five years. The company uses an MARR of 20%. It is estimated that the working capital requirement is $100,000 per year and rises with inflation, year zero being the base. The financial analyst is estimating a minimum inflation rate of 3% with a probability of occurrence of 70%. The same analyst thinks that there is a 30% chance of the inflation being 6% per year. What is the expected value of the present cost of the working capital? (10 points) We need to calculate the NPV separately under each of the two estimates of inflation. Then get the expected value of each and add them. Page 1 Initial Working capital 100,000 $ Initial Working capital 100,000 $ Length of project 5 years Length of project 5 years Inflation rate 3% Inflation rate 3% MARR 20% MARR 20% 0 1 2 3 4 5 0 1 2 3 4 5 Capital (100,000) (3,000) (6,090) (9,273) (12,551) 14,986 Capital (100,000) (3,000) (6,090) (9,273) (12,551) 130,914 NPV (112,125) NPV (65,537) Initial Working capital 100,000 $ Initial Working capital 100,000 $ Length of project 5 years Length of project 5 years Inflation rate 6% Inflation rate 6% MARR 20% MARR 20% 0 1 2 3 4 5 0 1 2 3 4 5 Capital (100,000) (6,000) (12,360) (19,102) (26,248) 47,782 Capital (100,000) (6,000) (12,360) (19,102) (26,248) 163,709 NPV (118,093) NPV (71,504) Inflation rate NPV Probability expected value Inflation ratNPV Probability expected value 3% (112,125) 70% (78,488) 3% (65,537) 70% (45,876) 6% (118,093) 30% (35,428) 6% (71,504) 30% (21,451) Combined (113,916) Combined (67,327) Year Year Year Year Alternate Alternate Initial Working capital 100,000 $ Initial Working capital 100,000 $ Length of project 5 years Length of project 5 years Inflation rate 3% Inflation rate 3% MARR 20% MARR 20% 0 1 2 3 4 5 0 1 2 3 4 5 Capital (100,000) (103,000) (106,090) (109,273) (112,551) 414,986 Capital (100,000) (103,000) (106,090) (109,273) (112,551) 530,914 NPV (210,248) NPV (163,659) Initial Working capital 100,000 $ Initial Working capital 100,000 $ Length of project 5 years Length of project 5 years Inflation rate 6% Inflation rate 6% MARR 20% MARR 20% 0 1 2 3 4 5 0 1 2 3 4 5 Capital (100,000) (106,000) (112,360) (119,102) (126,248) 447,782 Capital (100,000) (106,000)
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Final_ISE460_F06_sol - ISE 460 FINAL 12/07/06 Solution Fall...

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