3.2. Subject 2: Sensitivity Analysis, Staged Decisions and Decision Making under Risk
As individual members of the Group and as Integrated Group, you have to do the following:
• Theory overview: Work through Chapter 18 (Sensitivity Analysis, Staged Decisions) and Chapter 19 (Decision Making under Risk) in the Textbook (Blank & Tarquin: Engineering Economics Edition 8) – make sure that you understand the principles.
• Solving typical problems: After understanding the principles, solve the following problems by applying the principles from the book:
o Problem 2-1: ABC Plastics (Pty) Ltd manufactures class 1 PVC pipe and is investigating the production options of batch processing relative to continuous processing. Estimated cash flows are:
First cost, Rand
Annual cost, Rand per year
Salvage value, any year, Rand
The chief operating officer (COO) has asked you to determine if the batch option would ever have a lower annual cost worth than the continuous flow system using an interest rate of 15% per year. The continuous flow process was previously determined to have its lowest cost over a 5-year life cycle, but the batch process can be used from 3 to 10 years. If selecting the batch process is sensitive to its useful life, what is the minimum life that makes it more attractive? Solve (a) by hand, and (b) by spreadsheet.
o Problem 2-2: The CEO of BASF South Africa is trying to decide whether to start a new product line or purchase a small company. It is not financially possible to do both. To make the product for a 3-year period will require an initial investment of R2,500,000. The expected annual cash flows with probabilities in parentheses are R750,000 (0.5), R900,000 (0.4) and R1,500,000 (0.1). To purchase the small company will cost R4,500,000 now. Market surveys indicate a 55% chance of increased sales for the company and a 45% chance of severe decreases with an annual cash flow of R250,000. If decreases are experienced in the first year, the company will be sold immediately (during year 1) at a price of R2,000,000. Increased sales could be R1,000,000 the first 2 years. If this occurs, a decision to expand after 2 years at an additional investment of R1,000,000 will be considered. This expansion could generate cash flows with indicated probabilities, in parentheses, as follows: R1,200,000 (0.3), R1,400,000 (0.3), and R1,750,000 (0.4). If expansion is not chosen, the current size will be maintained with anticipated sales to continue. Assume there are no salvage values on any investments. Use the description given and a 15% per year return to do the following:
(a) Construct a decision tree including all values and probabilities.
(b) Determine the expected PW values at the “expansion/no expansion” decision node after 2 years provided sales are up.