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ESD.71 / 1.146 / 3.56 / 16.861 Engineering Systems Analysis for Design
Fall 2008
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View Full DocumentMIT subject ESD 71
Richard de Neufville
OPTIMUM CAPACITY EXPANSION
Prepared by: Ioanna Boulouta under the supervision of Professor Richard de Neufville
Part 1: OPTIMUM INCREMENT FOR CAPACITY EXPANSION – BASE CASE
GOALS:
1. Learn about capacity expansion problem and its possible optimal solution
2. Practice in use of NPV analysis on spreadsheets
GENERAL PROBLEM DESCRIPTION:
Alan Manne (1967), in his book “Investments for capacity expansion”, presents an analysis for
calculating optimal sizes of plant capacity to be added at several points in time. Under growing
demand and economies of scale there will be a choice between several time streams of
expenditure. For example, if a single large plant is built, advantage can be taken of economies of
scale in construction, however it requires a large initial investment. If several smaller plants are
built at different times, you may sacrifice some production economies but you also gain by
delaying part of the capital investment and avoiding interest payments.
In general, Manne’s result is that new capacity should be added in fixed increments that depend
on the intensity of the economies of scale and on the discount rate. [If there are no economies of
scale, the best policy is to build “just in time” according to need.
As economies of scale become
more important, it is worthwhile building larger, even though that means you have to pay
immediately for capacity you will only use later.]
These fixed increments represent demand
growth over a specific period, known as the cycle time for the addition of capacity.
To compare expenditures incurred at different dates, Manne uses the discounted cash flow
criterion (present value). In this exercise you will replicate his analysis.
MODEL BRIEF DESCRIPTION:
In his analysis, Manne assumed that (1) demand grows linearly over time and (2) there are no
imports in the market.
Hence, demand has to be satisfied at all times by internal production. This
exercise provides you with a model (Optimal Capacity Expansion base case.xls), based on the
same assumptions, that displays cash flows over 100 years. An infinite time horizon could also be
used.
The model uses discrete rather than continuous time analysis implied in Manne’s analytic version.
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 Fall '03
 lDavidMiller

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