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Alternative Capital Investment Future Sales Annual Revenue

Case Study#2
The XYZ Company

Katharine Rally is the vice president of operations for the XYZ Company. She oversees operations at a plant that manufactures components for hydraulic systems. Katharine is concerned about the plant's present production capability. She has reduced the decision situation to three alternatives. The first alternative, which is fully automation, would result in significant changes in present operations. The second alternative, which is semi-automation, involves fewer changes in present operations. The third alternative is to make no changes (do nothing).

As a manager of the plant management team, you have been assigned the task of analyzing the alternatives and recommending a course of action. The capital investment and annual revenue for the first two alternatives are shown in the following table:

Alternative Capital Investment Future Sales Annual Revenue
A $300,000 Good $250,000
Average $100,000
Poor $50,000
B $85,000 Good $100,000
Average $80,000
Poor $30,000

The annual revenue estimates are based on future sales of the components. The sales department estimates the probability of good, average, and poor future sales as 0.30, 0.60, and 0.1, respectively.

a. It is known that Katharine is a big fan of decision tree analysis. Based on a before-tax analysis (MARR=20% per year, study period of 5 years, and a salvage value of 20% of the capital investment) and the E(PW) as a decision criterion, determine which alternative is preferred. What would be the expected value of perfect information in this case?

b. Katharine has realized that additional information about future sales of the hydraulic components should reduce the uncertainty involved. Therefore, she asked the sales department to survey their customers about the future sales conditions. They conducted a survey and determined the conditional probabilities as shown in the following table. Based on this information, develop a two-stage decision tree and determine which alternative is preferred.

Conditional Probabilities of Survey Outcome
Given the Future Sales Condition
Survey Outcome Good (G) Average (A) Poor (P)
Optimistic 0.85 0.6 0.1
Not Favorable 0.15 0.4 0.9

c. Production manager, Adam Sinkosky, has informed Katherine that the annual revenue of alternative A is a normally distributed random variable within the range of $70,000 to $150,000. He is not sure how to explain it to Katharine. He asks you, an engineering management graduate, to write a brief but thorough summary about the normal distribution and its characteristics, explain the $70,000 to $150,000 range statement, and phrase "random samples that assumes a normal population."

d. Based on the past data, Katharine is further convinced that the capital investment, annual revenue, useful lives, and salvage values can be considered random variables with the following specified probability distributions. Adam also asks you to develop a simulation of 50 sample points of AW values at a MARR 0f 20%/year. Interpret your results and indicate which alternative should be selected.

Hint: Use the Random Number Generation (RNG) Data Analysis Tool package of Microsoft Excel. The online help function explains how to initiate and use the RNG to generate random numbers from a variety of probability distributions: normal, uniform (continuous variable), binomial, Poisson, and discrete. You solved a problem very similar to this one as part of your HW assignment when you took the MSE 604.

Alternative
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Parameter A B
--------------------------------------------------------------------------------------------
Capital Normal Normal
Investment Mean: $300,000 Mean: $85,000
Std. dev.: $50,000 Std. dev.: $500

Annual Normal Normal
Revenue Mean: $150,000 Mean: $85,000
Std. dev.: $10,000 Std. dev.: $500

Useful live Discrete uniform Discrete uniform
3 to 8 years with 3 to 7 years with
equal probability equal probability

Salvage Value Uniform Uniform
30,000 to $60,000 $10,000 to $20000

REPORT FORMAT
The report will be a formal report complete with a Title Page, Summary of Case Study, and Answer to Questions, and Appendixes. Appendixes used to include the computer outputs. Reports will be typed in a standard 12 point font and will be double-spaced on standard 8.5x11 papers with one inch margins on all four sides. The Reports will be retained by the department and will be normally considered to be a public document; it may be made available to others on request in the future.

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