C.

S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

C. S Nkabinde

Master of Philosophy in Engineering Management,

University of Johannesburg
Student No: 809648360

Advanced Engineering Economics: 14GIE4058

Assignment No 2

Due Date: 26 May 2014

Lecture: Mr. L Kruger

 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2
PROBLEM NO 1: WEIGHTED AVERAGE COST OF CAPITAL
Solution 1(a)

OPTION 1: 100% Equity Project Financing

Given:
Required Capital Investment R250 000
Return on Equity (Personal Investment) 8.5%
Annual Cash Flows (Annuities) (for 15 years) R15 000
Period 15 (years)

Solution:

Requirements - compute present worth of Equity Investment, to determine if it is worthwhile option:

Computation:
Present Worth (PW) = Initial Investment (CFo) + Annuity Payments (Annuity Factor)
PW = First Cost + Annuity (P/A, i%, N)
PW = - P0 + A (P/A, 8,5%, 15)
PW = - R250 000 + R15 000 (P/A,8.5%,15)
= - R250 000 + R15 000 (8,3042)
= - R250 000 + R124 563
= - R125 437

Analysis: The Present Worth is - R125 437, which evince that if the Project Capex was to be sourced from 100% equity at 8.5 return on equity, the project will fail
to recoup the initial investment (first cost) and/or will not break-even, despite the annual income of R15 000 for 15 years.

Conclusion: The project doesn’t meet the minimum rate of return that is acceptable, and as such it doesn’t the meet the [capital investment] requirements. It is
safe to conclude that it is note worthwhile to get 100% Equity financing (personal investment), given that the net present worth reflects a deficit of –R125 437,
which means that the return on equity is less than zero (MAAR < 0).
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

Solution 1(b)

OPTION 2: Debt (Project) Financing

Given:
Required Capital Investment R250 000
Return on Debt (Borrowing ) 60% of the Required Capital (Capex) 60% (R250 000) = R150 000
Annual Cash Flows (Annuities) (for 15 years) R15 000
Period 15 (years)
Return on Debt (loan) 9%

Solution:
Requirements - compute present worth of Equity Investment, to determine if it is worthwhile option:

Computation:

Given Debt-Equity (D-E) Mix of 60%-40% Project Financing

Debt Portion (Principal) = R250 000 (0.60) = R150,000 = Principal Loan (CFo) = Po
Loan Repayment Amounts (Annuity) = Principal Loan (CFo) (A/P, i%,N)
= - R150 000 (A/P,9%,15)
= - R150 000 (0,12406)
= - R18 609 p.a

Analysis: This means that for 15 years, the total amount will be R18 609 x 15 = R279 135, if this amount discounted to what it is worth today, yield R76 633,
which is below the Project Loan of R150 000. Another way of looking at this is the comparison of Annuities. The project income generated annually for 15 years,
is R15 000, but borrowing R150 000 at 9%, which requires a loan repayment annual amount of R18 609 (Cash outflows). The required repayments annual
installment is therefore is more than the project income (Cash inflows). There will be an annual deficit of R18 609 less R15 000, which is R3 609. This simply
means that the project income is not sufficient to recoup or repay the R150 000 loan taken to invest in this project, or the initial investment cannot be recovers
is the D-E Mix of 60%-40%, was to be used as gearing (capital structure of capital investment). Returns on such a gearing capital (investment) structure will not
give the required capital recovery.
.
Conclusion: Therefore it is safe to conclude that borrowing R150 000 at 9% is not a worthwhile investment.
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

Solution 1(c)

WEIGHTED AVERAGE COST OF CAPITAL

Given:
Initial Equity Investment Capex (40%) 40% x (R250 000) = R100 000
Return on Debt (Borrowing ) 60% of the Required Capital (Capex) 60% (R250 000) = R150 000
Period of Investment 15 years
Cost of Equity is 8.5% 8.5%
Cost of Debt 9%
Weighted Average Cost of Capital (WACC) ? (Unknown)

Computation of Cost of Capital

Requirement: Cost of Equity is 8.5% and Cost of Debt is 9% Compute the average cost of capital, and present worth of cost of capital
WACC = 0.6(9%) + 0.4(8, 5%) = 0,54 + 0, 34 = 0, 88
MARR(Cost of Equity) = 8.8%

Annual Net Cash Flow = Project Annual NCF – Annual Debt Payment
= + R15 000 – R18 609
= - R3 609

Portion of the Equity Finance = R250 000(40%) = R100 000

PW of 40% Equity = -R100 000 + (-R3609) (P/A,8.8%,15)
PW40%Equity = -R100 000 + (-R3609) (8, 1567)
PW40%Equity = -R100 000 - R29 438
PW40%Equity = -R129 438

Given that the Net Present Worth of 100% Equity Finance is - R125 437, then compute the annuity equivalent – Annuity = - R125 437(P/A, 8.5%, 15) = R15 105.
This means that the project can be fully funded at the annuity expense of R15 105 p.a. The 100% equity finance (R18 609 - R15 110) = R2 959 cheaper than the
60% loan finance. In addition, just the 40% Capex option, of the required capital, requires annual repayments of R18 689, for 15 years, which is R1051 more
expense that the 100% equity financing option.

Conclusion: Equity Finance option is much better then D-E mix debt funding of 60%-40. Besides the fact that both options do not meet the MARR, financing
the project in this case proves to be a better option both qualitative and quantitatively.
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

PROBLEM NO 2: NORMALIZED WEIGHTS

Solution 1(c)

ATTRIBUTES RATIONALE IMPORTANCE IMPORTANCE SCORE WEIGHT(S) [Wi = Score/27,5] %

1. Flexibility Most NB = 100% 100% 10 0,3636 36,36%
2. Safety 50% [Uptime] 25% 2,5 0,0909 9,09%
3. Uptime 1/2[Flexibility] 50% 5 0,1818 18,18%
4. Speed Same as = Uptime 50% 5 0,1818 18,18%
5. Rate of Return 2 [Safety] 50% 5 0,1818 18,18%
TOTAL 27,5 1,0000
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

PROBLEM NO 3: ECONOMIC SERVICE LIFE?

Solution 3(a)

Given the following:

MARR = 18% Period = 6 years

Life First Cost (P=R100 Operational Cost Salvage Value Annual

(n = no of years) 000) [AOC=65+10xn) x 1000, n>=1] S = P x 0.85n Worth
0 R 100 000 R 100 000
1 R 75 000 R 85 000 R108 000
2 R 85 000 R 72 250 R110 316
3 R 95 000 R 61 413
4 R 105 000 R 52 201
5 R 115 000 R 44 371
6 R 125 000 R 37 715

It is clear that there is uniform decline by 15% in salvage value, and uniform growth by R10 000 in operational costs. Given this prevalent
growth, the uniform growth gradient equation must be used as indicated hereunder.

Year 1, Annual Worth(yr1) = First Cost (A/P, i%, n) + Salvage (A/F, i%, n) – Annual Operating Cost

AW(yr1) = -P (A/P, i%, k) + S(A/F, i%, k) – AOC

= -R100 000 (A/P,18%,1) + R100 000(0.85)1(A/F,18%,1) – R75 000

= -R100 000 (1,1800) + R85 000(1) – R75 000

= -R108 000
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

Year2: AW(yr2) = -R100 000(A/P,18%,2) + 100,000(0.85)2(A/F,18%,2) – 75000 – 10 000(A/G,18%,2)

= -R100 000 (0.6387) + R100 000(0,72 250) (0,4587) – 75 000 – 10 000(0,4587)

= -R110 314, 798

Annual Worth for the second year is -R110 315

Year3: AW(yr3) = -R100 000(A/P,18%,3) + 100 000(0.85)3(A/F,18%,3) – 75 000 – 10 000(A/G,18%,3)

= -R100 000 (0,4599) + R100 000(0,61 413) (0,2799) – 75 000 – 10 000(0,8902)

= -R112 701

Annual
Adjusted Operating
Year (n) -P (A/P, i%, k) -FC(A/P; i%; N) AOC Cost Total AW
0
1 -R 118 000 R 85 000 -75000 -R 108 000,00
2 -R 63 870 R 33 142 -R 4 587 -75000 -R 110 314,798
3 -R 45 990 R 17 191 -R 8 902 -75000 -R 112 701,176
4 -R 37 170 R 10 009 -R 12 947 -75000 -R 115 108,122
5 -R 31 980 R 6 202 -R 16 728 -75000 -R 117 505,983
6 -R 28 590 R 3 994 -R 20 252 -75000 -R 119 847,605

The Economic Service Life is 1 year, and the corresponding Annual Worth (AW) is R108 000 (One hundred and Eight Thousand Rand Only).
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2
Solution 3(a)
(b) Given the findings that the annual worth of the ESL is R108, for the first year (Year 1), and the assumption that in the 6th Year everything will be the same save
the Annual Worth will be that of the Economic Service Life, the following equation must be used to compute an equivalent Present Value

Year 1, Annual Worth(yr1) = First Cost (A/P, i%, n) + Salvage (A/F, i%, n) – Annual Operating Cost

But given AW(year 1) = AW(year 6), and all else remain unchanged (the same)

Therefore AW(Year 1) = First Cost (A/P, i%, 6) + Salvage (A/F, i%, 6) – Annual Operating Cost(at year 6, with uniform growth)

-AW(Year 1) = -P(A/P,18%,6) + P(0.85)6(A/F,18%,6) – 75 000 – 10 000(A/G,18%,6)

Solve for P =? Using (based on) the above equation

P(A/P,18%,6) - P(0.85)6(A/F,18%,6) = – 75 000 – 10 000(A/G,18%,6)] + [AW(Year 1)]

P[(A/P, 18%,6) - (0,85)6(A/F,18%,6)] = -75 000 – 10 000 (A/G,18%,6)

P[(0.2859) - (0.3771)(0.1059)] = -75 000 – 10 000(2, 0252)

P[0,2859 - 0,03993)] = - 95 252 + 108 000

P (0.24596) = 12 748 = 12 748/0.2459

P = 51 828,489
Analysis: Thus the present worth at AW (year1) = AW (year 6) is R51 828, therefore the first cost will have to be reduced with X = FC – P, which is
R100 000 - R51 828,489, resulting to R48 171, 511, an equivalent of R48 172.

Conclusion: It is found that the first cost will have to be reduced by R48 172 to decrease from R100 000 to R51 828
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2
PROBLEM NO 4: WHAT IS THE RIGHT PRICE?

Solution 4(a)

Given:
FIXED COST VARIABLE COSTS R/Unit
Administrative R 30 Materials R 2 500
Salaries and benefits: 20% of (350) R 70 Labour R 200
Equipment R 100 Indirect Labour R 2 000
Space etc. R 55 Subcontractor R 600
Computers: 1/3 of (100) R 33 Misc. Cost R 200
TOTAL R 288,33 TOTAL R 5 500

(a) Determine the minimum revenue per unit to break even at the current production volume of 5 000m^3 per
year?

NB: Profit at Break Even Point, Profit =0

Profit = (r - v) Q - FC (From this equation, solve for r =?)

0= (r - v) Q - FC
(r-v)Q = FC
r-v = FC/Q
r= (FC/Q) + v
Plug in, the given values

r= (R288 333,33 /5000) + R5500 000

R 57 666,6667 R 5 500 000
r= R 5 557 666,7

The minimum revenue per unit to break even is R 5 557 666,7

 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

Solution 4(b)

Given:
FIXED COST VARIABLE COSTS R/Unit
Administrative R 30 Materials R 2 500
Salaries and benefits: 20% of (350) R 70 Labour R 200
Equipment R 100 Indirect Labour R 2 000
Space etc. R 55 Subcontractor R 600
Computers: 1/3 of (100) R 33 Misc. Cost R 200
TOTAL R 288,33 TOTAL R 5 500
If production capacity increase by 3000, Determine the required revenue per unit to get a profit target of R500 000?

Profit = R 500 000

volume = 8000

Profit = (r - v) Q - FC (From this equation, solve for r =?)

P = (r - v) Q - FC
(r-v)Q = FC + P
r-v = (FC+P)/Q
r = [(FC+P)/Q] + v

R500 000 + R288 333 + 5 500 000

8000

R 788 333,33 + R5500000

8000

revenue = R 5 500 098,54

The profit target of R500 000, can be obtained if the revenue per unit is R5 500 099
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2

PROBLEM NO 5: BUY OR MAKE

SOLUTION TO PROBLEM NO 5

INDIRECT COST ALLOCATION FOR MAKE ALTERNATIVE

Department Allocation Rate/hour Duration (Basis hours) Indirect Cost Allocation
A Labour hours (direct) 10 25000 R 250 000
B Machine hours 5 25000 R 125 000
C Labour hours (direct) 15 10000 R 150 000
TOTAL INDIRECT ALLOCATION COST = R 525 000

Annual Operating Cost (Make Option) = Direct Labour + Direct Materials + Indirect Allocation
R 500 000 R 300 000 R 525 000

Annual Operating Cost = R 1 325 000

Annual Worth (Make) = INITIAL INVESTMENT (P)(A/P, I, N) + SALVAGE VALUE(A/F, I, N) + ANNUAL OPERATING COST
2 000 000(A/P,15%,10) + 50000(A/F,15%,10) + R 1 325 000
(-2000000) x (0.1993) (50000) x (0.0493) R 1 325 000
R 398 600 R 2 465 R 1 325 000
AW(Make) = - R 1 726 065

SUMMARY OF ANALYSIS AND FINDINGS

Findings
1. Given that the current carafes are purchased with AW of -R1 500 000 (R1.5 million) AW (Purchase Cost) R 1 500 000
2. Whereas the make alternative will cost an Annual Worth of -R1 726 065 (-R1.73 million) AW (Make Cost) R 1 726 065
Net Savings R 226 065
Recommendations and Conclusions
The company will make a net savings of R 226 065, if the make alternative is chosen, and as such it is recommended that the company
should rather make the components in house, instead of buying them
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2
PROBLEM NO 6: WHAT PERCENTAGE (ERR)?

Given the following information:

Item No Item Description Value Units
1 Capacity Phase 1 1,8 Mega ton p.a
2 Capacity Phase 2.1 3,6 Mega ton p.a
3 Capacity 2.2 5,4 Mega ton p.a
4 Revenue (Production) [2015] R 500 Per ton
5 Cost (Production) [2015] R 150 Per ton
6 Uniform Gradient Cost (gC) g= 1+3% Per year
7 Uniform Gradient Revenue (gR) g = 1-3% Per year
8 Fixed - Cost Phase 1 [2015-] R 40 million
9 Fixed - Cost Phase 2 [2019] R 80 million
10 Remediation Cost R 90 million
11 Borrowing Rate (k) 16% Per year
12 Investment Rate ( r ) 15% Per year
13 Period (In years = n) 11 Years
14 MARR 18% Per year

NB: Formulae employed

PRODUCTION = Total Production (Revenue) - TOTAL Cost of Production (Variable Cost plus Fixed Cost)
Production Revenue - Variable Costs + Fixed Costs
Prod Capacity x Revenue (price) - Prod Capacity x Variable Cost - (Given figure)
n n
(1,8 x 500)(1-gR) - (1.8 x 150) (1+gC) - FC
Year 2015 (1,8 x (500) (0,97)0 - (1,8 x (150) (1+3%)0 - 40 = R590
1 1
Year 2016 (1,8 x (500) (0,97) - (1,8 x (150) (1+3%) - 40 = R554, 90
Year 2017 (1,8 x (500) (0,97)2 - (1,8 x (150) (1+3%)2 - 40 = R520,37
3 3
Year 2018 (1,8 x (500) (0,97) - (1,8 x (150) (1+3%) - 40 = R486,37
4 4
Year 2019 (1,8 x (500) (0,97) - (1,8 x (150) (1+3%) - 40 = R452.88
Year 2020 (3,6 x (500) (0,97)5 - (3,6 x (150) (1+3%)5 - 80 = R839,71
6 6
Year 2021 (5,4 x (500) (0,97) - (5,4 x (150) (1+3%) - 80 = R 1201,84
Year 2022 (5,4 x (500) (0,97)7 - (5,4 x (150) (1+3%)7 - 80 = R1105,36
8 8
Year 2023 (5,4 x (500) (0,97) - (5,4 x (150) (1+3%) - 80 = R1010,02
 C.S Nkabinde, Student No: 8096483360 Advanced Engineering Economics Assignment No 2
Steps to Compute ERR

Step 1: Based on given data and above calculations, determine Net Cash Flow (NCF) for each year;

Step 2: Discount all negative Cash Flows (Outflows), to year zero, using P = F(P/F; Borrowing rate; N) = P (1+16%)-N

Step 3: Compound all positive incoming Cash Flows (Inflows) to the Future value of year 2023, using F = P(F/P; Investment rate; N) = P (1+15%)N

Step 4: Determine Sum of FW+, and Sum PW-, forthwith use equation: FWn+= PW-(F/P, ERR%, N) to find External Rate of Return (ERR)