ESE400/540 Midterm Exam #1

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: [email protected]
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.

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ESE400/540 Midterm Exam #1

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

What will be supplied:

Allison Higgins, TA: [email protected]

The Principles of Engineering Economy need not

Reading and analyzing financial statements.

Develop the Alternatives

Problem recognition, formulation, and evaluation

Chapter 2. Cost Concepts &

Know optimal and break-even demand/ production

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

3. Cost Estimation Techniques

Per unit factors

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

Chapter 3: Exam Exclusions

Direct and indirect costs

single payment compound amount factor

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

Know deferred annuities (4.9)

Understand geometric sequence problems (4.12):

and Convenience Rate footnote on Page 150

Interest rates varying with time (4.13)

Continuous compounding will not be on the

You must use equivalence formula

Understand Minimum Attractive Rate of

PW: Present worth (5.3)

FW: Future worth (5.4)

Objective: Keep as much capital as possible

Know how to use:

Greatest positive (or least negative) PW, FW or

External interest rate:

Evaluate the incremental return of the

Understand payback period: simple &

Do not compare IRRs of mutually exclusive

Incremental Analysis Steps:

Rank order from lowest to highest

Companies typically finance their

Alternatives must be on a comparable

Raising equity (selling ownership

Lenders and investors have opportunity

Capital Asset Pricing Model

CAPM: Capital Asset Pricing Model

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

A companys beta measures the volatility

=0 : Risk-free stock (hypothetical)

Unlevered Asset Beta

D = Amount of debt in companys capital structure

Re-Levered Equity Beta

Weighted Average Cost of Capital

= debt fraction of capital structure

Illustrative WACC Calculation

Must show how answers are derived.

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