ESE400/540 Midterm Exam #1

Tuesday, Oct 6th, 3:00 4:30pm

Chemistry Building: 102
What to bring:
One, two-sided, 8 x11 sheet of personal notes
Pencils or pens

What will be supplied:

Calculator
Appendix C: Interest and annuity tables (including
formulas)
Blue book
Exam Questions

Allison Higgins, TA: ahigg@seas.upenn.edu

A calculator will be provided for use during the exam (model TI-30XA).
Personal calculators may not be used. You may borrow a calculator
in advance to become familiar with it (recommended).

Exam Topics
Textbook chapters 1, 2, 3, 4, 5 and 6
Lecture material:
Corporate Finance Overview
Minimum Attractive Rate of Return (MARR)
Capital Asset Pricing Model (CAPM)
Weighted Average Cost of Capital (WACC)
Pricing

Chapter 1. Introduction

Exam Exclusions

The Principles of Engineering Economy need not

be memorized, but a working knowledge of them
must be reflected in your answers, where
applicable:

Reading and analyzing financial statements.

Optimal capital structure.
1.
2.
3.
4.
5.
6.
7.

Develop the Alternatives

Focus on the Differences
Use a Consistent Viewpoint
Use a Common Unit of Measure
Consider All Relevant Criteria
Make Uncertainty Explicit
Revisit Our Decisions

Chapter 1 (contd)
Similarly the Engineering Economic Analysis
Procedure need not be memorized, but a working
knowledge of it must be reflected in your answers,
where applicable:
1.
2.
3.
4.
5.
6.
7.

Problem recognition, formulation, and evaluation

Development of the feasible alternatives
Development of the cash flows for each alternative
Selection of a criterion ( or criteria)
Analysis and comparison of the alternatives
Selection of the preferred alternative
Performance monitoring and post-evaluation results

Chapter 2. Cost Concepts &

Design Economics
Terminology
There will not be a vocabulary test.
You will be expected to understand the terminology discussed
in the first session (e.g., price elasticity, life cycle costs, fixed
and variable costs, sunk costs, etc.).

Know optimal and break-even demand/ production

points (2.2)
Know cost-driven design optimization (2.3)
Discrete Primary Cost Drivers
Continuous Primary Cost Drivers

Present economy studies (2.4) will not be on the exam.

Pricing

3. Cost Estimation Techniques

Indexes
Cn = Ck (In / Ik)
Weighted indexes

Per unit factors

Parametric cost estimation: C = f (Cost Driver)
Power sizing: CA = CB (SA / SB)X
X: cost capacity factor (eg, 0.6)

Learning curve:
Zu = K (un)
K = resources to produce 1st unit
n = (log s / log 2) where s = learning curve parameter

Tx = K un , summed over u=1 to x

Chapter 3: Exam Exclusions

Developing a cost estimating
relationship (CER)

Bottom-up approach
Work Breakdown Structure
Appropriate levels of accuracy

Direct and indirect costs

Contingency allowance
Margin and profit

Top-down approach
8 steps to better pricing
3 pricing strategies
If the dogs dont eat the dog food

Chapter 4. Money-Time
Relationships and Equivalence
Assume interest is compound, not simple (4.3)
Understand the concept of equivalence (4.4),
notation and cash-flow diagrams (4.5)
$9,000

-$5,000
-$20,000

S = $2,000

Chapter 4 (contd)
Understand the application of interest formulas
(4.6 & 4.7):
(F/P, i%, N):
(P/F, i%, N):
(F/A, i%, N):
(P/A, i%, N):
(A/F, i%, N):
(A/P, i%, N):

single payment compound amount factor

single payment present worth factor
uniform series compound amount factor
uniform series present worth factor
sinking fund factor
capital recovery factor

Interest formulas will be provided (Appendix C: Pg 1)

Chapter 4 (contd)

Chapter 4 (contd)

Know deferred annuities (4.9)

Know the use of multiple interest formulas (4.10)
Understand uniform gradient problems (4.11):
(A/G, i%, N): gradient to uniform series
(P/G, i%, N): gradient to present equivalent
(F/P, i%, N): gradient to future equivalent
P

Convenience Rate
Footnote P.150 (16th Ed)

Understand geometric sequence problems (4.12):

A1 1

P / F, i%,N F / P, f %,N
i f

A 1N P / F, i%,1

and Convenience Rate footnote on Page 150

Chapter 4 (contd)
Know how to deal with:

Where

A1
P / A,iCR %,N
1 f

iCR

i f
1 f

Interest rates varying with time (4.13)

Nominal and effective interest rates (4.14)
Compounding more often than annually (4.15)
ieff

r
M

Continuous compounding will not be on the

exam.

You must use equivalence formula

notations from this course
(F/P, i%, N)
(P/F, i%, N)
(F/A, i%, N)
(P/A, i%, N)
(A/F, i%, N)
(A/P, i%, N)

Chapter 5. Applications of
Money-Time Relationships

(A/G, i%, N)
(P/G, i%, N)
Geometric series:
P

A1 1

P / F, i%,N F / P, f %,N
i f

Understand Minimum Attractive Rate of

Return (5.2)
Know how to use:
f

PW: Present worth (5.3)

Understand bond value (5.3.2)
Understand CW: Capitalized worth (N) (5.3.3)

or convenience rate

FW: Future worth (5.4)

AW: Annual worth (5.5)

Chapter 6. Comparing
Alternatives

Chapter 5 (contd)

Objective: Keep as much capital as possible

invested at returns MARR.
Criterion:

Know how to use:

IRR: Internal rate of return (5.6)
ERR: External rate of return (5.7)

Greatest positive (or least negative) PW, FW or

AW @ i = MARR
IRR or ERR MARR

External interest rate:

External interest rates: fin and inv

Evaluate the incremental return of the

incremental investment between
alternatives.

Understand payback period: simple &

discounted (5.8)

Chapter 6 (contd)

Chapter 6 (contd)

Do not compare IRRs of mutually exclusive

alternatives. Instead, use incremental method:

Incremental Analysis Steps:

1.

2.

3.

Rank order from lowest to highest

investment cost
Base = lowest cost, acceptable
alternative
Next highest cost alternative is preferable
if its incremental investment produces an
incremental benefit (ie, return MARR).

E.O.Y.

C-B

D-B

-$40,000

-$50,000

-$65,000

-$75,000

-$15,000

-$25,000

11,000

18,000

21,000

21,000

3,000

3,000

11,000

18,000

21,000

21,000

3,000

3,000

11,000

18,000

21,000

21,000

3,000

3,000

11,000

18,000

21,000

46,000

3,000

28,000

PW(10%)

-$5,131

$7,058

$1,567

$8,643

-$5,490

+$1,585

-8.4%

12.0%

IRR

3.9%

B (Base)

16.4%

11.1%

14.6%

Capital Structure

Chapter 6 (contd)

Companies typically finance their

operations by a combination of:

Alternatives must be on a comparable

basis (6.5):
Repeatability assumption
Co-terminated assumption
Imputed market value technique

Raising equity (selling ownership

interests, i.e., stock)
Borrowing (incurring debt)
Re-investing profits (retained earnings)

Corporate Finance
Income

Return on Capital
Fixed
Assets

Equity
Common
Preferred

Debt
Loans
Bonds

Expenses

Capital Structure

Capital Allocation
[ESE400/540]

Retained
Earnings

Dividends to
Shareholders
New
Retained
Earnings

Lenders and investors have opportunity

costs related to their alternatives.
Return on capital must meet (and
preferably exceed!) its opportunity cost.
Return on capital is a key criterion in the
proper evaluation of engineering projects.
M.A.R.R. = minimum attractive return.

Capital Asset Pricing Model

RS = RF + Risk Premium
Expected Return on Risky Asset

Quantity of Risk

CAPM: Capital Asset Pricing Model

Pricing the Equity Component
- Market Perspective -

RS

RF
Riskless Rate

RM RF
Market Risk Premium:
Price of Risk

where RM = expected return on a diversified market portfolio of stocks.

Asset Beta

A companys beta measures the volatility

(riskiness) of a companys common stock
price relative to the volatility of a fully
diversified portfolio of common stocks.

=0 : Risk-free stock (hypothetical)

<1 : Company less risky than diversified portfolio
=1 : Company risk equivalent to diversified portfolio
>1 : Company more risky than diversified portfolio

Unlevered Asset Beta

Asset

D
D E

Debt

E
D E

U
Asset

D E

Equity

Where:

1 t ib

E
D E

Debt

Equity

D = Amount of debt in companys capital structure

E = Amount of equity in companys capital structure
(D/D+E) = Leverage (a.k.a. )

Re-Levered Equity Beta

At Target Leverage,

1
Equity ,2

U
Asset
2

Equity

Weighted Average Cost of Capital

WACC

D
D E

Equity

Asset

ea

= debt fraction of capital structure

t = effective tax rate
ib = cost of debt financing
ea = cost of equity financing

Illustrative WACC Calculation

WACC is calculated as follows assuming a
capital structure of 70% equity and 30% debt
with a 40% effective tax rate:
Capital Structure

Cost

After-tax

Weighted
cost

Debt

30%

5.5%

3.3%

1%

Equity

70%

20%

20%

14%

WACC:

15%

Exam Format
Ten questions:
Must answer 7 required questions
Additional optional questions may be answered for
extra credit (does NOT affect exam grade).

Must show how answers are derived.

Answers must be clearly identified.
Must use most efficient methods taught in
ESE400/540 to solve exam questions.
Must express answers with appropriate
significant figures.