ECONOMIC JUSTIFICATION OF A

FLEXIBLE MANUFACTURING SYSTEM

Vatsal Parikh
Romil Modi
Srinivas Shreyas Nirgund
Madhusudhan Subramani
Simon K John





MECH 6335-501/OPRE 6340
FLEXIBLE MANUFACURING
PROF. STECKE
FALL 2013


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Table of Contents

1. INTRODUCTION ......................................................................................................................................... 3
1.1 LITERATURE REVIEW ........................................................................................................................... 3
1.2 FLEXIBLE MANUFACTURING SYSTEMS IN THE AUTOMOTIVE INDUSTRY ........................................... 4
1.3 METHODS OF INVESTMENT EVALUATION FOR FLEXIBLE MANUFACTURING SYSTEMS ..................... 5
2. JUSTIFICATION METHODS ......................................................................................................................... 8
2.1 JUSTIFICATION METHOD - AN EXAMPLE ............................................................................................ 8
2.2 NET PRESENT VALUE (NPV) ................................................................................................................. 9
2.3 SIMPLE PAYBACK METHOD ............................................................................................................... 10
2.4 PROFITABILITY INDEX (PI) ................................................................................................................. 11
2.5 INTERNAL RATE OF RETURN (IRR) ..................................................................................................... 11
3. GENERATING THE DATA TO USE FOR JUSTIFICATION ............................................................................. 12
3.1 GENERATING THE DATA TO USE IN JUSTIFICATIONS ........................................................................ 17
4. ASSESSMENT CRITERIA............................................................................................................................ 17
5.ANNUAL OPERATION CASH FLOW FROM A FLEXIBLE MANUFACTURING SYSTEM ................................. 18
6. THE IMPACT OF CHANGES IN FOREIGN EXCHANGE RATE ON INVESTMENT PROJECT EVALUATION
WITH REAL OPTIONS ANALYSIS................................................................................................................... 20
The Linear Model .................................................................................................................................... 20
The Second Order Polynomial Model ..................................................................................................... 21
The Third Order Polynomial Model ........................................................................................................ 22
6.1 MAJOR FACTORS AFFECTING THE REGRESSION MODELS ................................................................ 24
7. CONCLUSION ........................................................................................................................................... 26
8. REFRENCES .............................................................................................................................................. 26




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1. INTRODUCTION
1.1 LITERATURE REVIEW
Every year corporations in various industries around the world are making large investments in
research and development, in new product design, as well as in production and operation
facilities in both home markets and international markets in order to provide better service to
customers and stay competitive in their industries.
With increasing technology advancement and global economic cooperation and
competition, more than ever before, economic evaluation of investment project in the
manufacturing industry becomes more and more important in the management decision making
process. Careful investment evaluation, market research, and competitive advantage assessment
have therefore become indispensable steps to reach a well-informed, strategically correct
investment decision.
In the automotive industry, where globalization has long been a reality for more than a
century, competition at home and abroad has intensified in recent years. Leading manufacturers
in the automotive industry invest large amount of funds each year in research and new vehicle
technology development in order to have a competitive edge in new product development.
Financial investments are also made to upgrade or build new manufacturing facilities for the
production of existing and new models of different types of vehicles for different market
segments. Both original vehicle manufacturers and part and component suppliers are making
investments to expand their production capability in both home and international markets.
Because of their apparent advantage to switch from production of one type of product to another,
to expand production capacity, as well as to benefit from longer service life, modern flexible
manufacturing systems have gained wider application in the automotive industry as well as in
other manufacturing industries. Due to the relatively large initial investment and the need to plan
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for phased expansion or reconfiguration investments, traditional discounted cash flow (DCF)
techniques of economic evaluation may not be able to fully capture the benefit from flexible
manufacturing systems. Real options analysis, on the other hand may provide a better framework
for the economic evaluation of financial investment in such systems.
A brief literature review will be provided in this chapter to understand the current state of
research activities in flexible manufacturing systems and their applications; methods of
economic evaluation of investment in flexible manufacturing systems; and the application of the
real options approach in the evaluation of investments in flexible manufacturing systems.
1.2 FLEXIBLE MANUFACTURING SYSTEMS IN THE AUTOMOTIVE INDUSTRY
The dramatic improvement in quality and productivity by some of the Japanese automobile
manufactures in the last ten to fifteen years has in large part been contributed to the successful
implementation of advanced manufacturing technology and lean manufacturing facilities for the
production of existing and new models of different types of vehicles for different market
segments. Both original vehicle manufacturers and part and component suppliers are making
investments to expand their production capability in both home and international markets.
Because of their apparent advantage to switch from production of one type of product to another,
to expand production capacity, as well as to benefit from longer service life, modern flexible
manufacturing systems have gained wider application in the automotive industry as well as in
other manufacturing industries. Due to the relatively large initial investment and the need to plan
for phased expansion or reconfiguration investments, traditional discounted cash flow (DCF)
techniques of economic evaluation may not be able to fully capture the benefit from flexible
manufacturing systems. Real options analysis, on the other hand may provide a better framework
for the economic evaluation of financial investment in such systems.
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A brief literature review will be provided in this chapter to understand the current state of
research activities in flexible manufacturing systems and their applications; methods of
economic evaluation of investment in flexible manufacturing systems; and the application of the
real options approach in the evaluation of investments in flexible manufacturing systems.
1.3 METHODS OF INVESTMENT EVALUATION FOR FLEXIBLE MANUFACTURING
SYSTEMS
With the increasing trend of the application of flexible manufacturing systems in the automotive
industry and other industries, corporate executives and plant managers have come to a better
understanding of the benefits of product flexibility and long term manufacturing efficiency
offered by flexible manufacturing systems. Due to the relative large financial investment
required and the technical complexity involved in design and implementation of a flexible
manufacturing system, and due to the need for financial accountability in every investment
project, companies that intended to implement flexible manufacturing systems have to perform a
carful economic evaluation of financial investments in such manufacturing systems in order to
make sure that while strategically beneficial with advanced technology, product offering
flexibility, and production efficiency, flexible manufacturing systems do provide positive
economic value to the investing company. In other words, strategically beneficial projects have
to be economically successful in order to justify the required investment and increase the value
of the company. Since the early 1990s, a large number of academic research and business
analysis papers have been published on investment evaluation of flexible manufacturing systems
(Chen and Small 1996, Burcher and Lee 2000, Ajah and Herder 2005).
In an early survey of capital budget methods, Schall, Sundem and Geijsbeek Jr. presented their
findings in 1978 in The Journal of Finance. Out of the 189 responses from large corporations in
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the United States, 86% of the companies used the Internal Rate of Return (IRR) or Accounting
Rate of Return (ARR) in capital budgeting practice, 74% of the responding companies used the
Payback Period (PBK) to compare investment projects, while 56% of the companies applied Net
Present Value (NPV) analysis in capital budgeting. Of all the companies responding to the
question of risk consideration in capital budgeting, 90% raised the required rate of return or the
discount rate in NPV calculation to account for added project risk.
John Graham and Campbell Harvey reported in a more recent survey in 2001 of 4440 companies
about corporate capital budgeting and capital structure. Out of the 392 companies that responded,
the survey found that most respondents cited net present value (NPV) and internal rate of return
(IRR) as their most frequently used capital budgeting techniques; with 74.9% of CFOs always or
almost always using NPV, and 75.7% always or almost always using IRR. However, large
companies were significantly more likely to use NPV than were small firms. Other than NPV
and IRR, hurdle rates and payback period was the most frequently used capital budgeting
technique by 56% of the companies. After IRR, NPV, hurdle rates, payback period, and
sensitivity analysis, real options analysis was used in capital budgeting by 27% of the companies,
this reflected a significantly increasing application of real options analysis in corporate
investment evaluation since the last survey in 1978 by Schall and others, in which non of the
responding companies indicated the use of real options evaluation in capital budgeting.
Even though real options analysis is a fairly new capital budgeting technique, over a
quarter of the companies participated in the 2001 survey reported using it in their investment
evaluation. It is believed that the increasing application of real options analysis in corporate
investment evaluation since the later 1970s reflected the following facts:
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(1) With the wide application of financial option pricing theory and increasingly large volume of
trading activities in financial options on stock and stock indexes, interest rates, foreign exchange,
as well as real metals and other commodities, the research on the Economic justification of FMS.
Applying financial option pricing theory to real world investment evaluation practice,
real option analysis is quickly emerging as a new approach to economic evaluation and selection
of strategic investment alternatives in non-financial industries.
The objective of this research is to apply real options theory to evaluate financial
investments in flexible manufacturing systems in the automotive industry and help to identify
future growth opportunities both in national and international markets. Models were developed
to capture the strategic value of management and operational flexibility for capital investments in
a flexible manufacturing system.
Financial option pricing models were reviewed with the analogy between financial option
pricing and real option analysis discussed in order to establish the real options analysis
framework.
An evaluation model was also developed to account for foreign exchange risk for
financial investments in foreign countries. Real options analysis was applied to evaluate
investments in flexible manufacturing systems in the automotive industry for both the economy
of scope and the economy of scale. Advantages and concerns related to the application of real
options analysis are discussed with brief comments on future research needs.
Economic justification of FMS is basically a calculation of the return on investment over
time against the cost of implementing an FMS.
One approach would be a comparison of the cost of the machine and software versus
labor, floor space, sales, lead time, production, automation.
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Economic justification can be calculated by comparing the data from before and after
implementing the system. Factors include the process cycle time which the conventional
system or job shops would take in comparison to the FMS, the efficiency of the
production as compared to the original systems.
We should also factor in the time it takes to resolve technical glitches and reach a
smoothly functioning system. Thus the question becomes does the cost of buying
implementing such an expensive system justify the production and profit which the
company can make?
2. JUSTIFICATION METHODS
Most of the organizations today use a combination of the methods that are described below.
Important concepts for economic justification are given here:
The time value of money is important.
A dollar today is worth more than a dollar tomorrow.
The expected cash flows from each year of the project is discounted against the
companys desired rate of return.
2.1 JUSTIFICATION METHOD - AN EXAMPLE
ABC Company is considering an FMS for a manual assembly process. It will cost
$25,000 in planning and engineering costs for three years. In the fourth year, the project
will require a capital investment of $200,000. The system will be up and running in year
five. The system will increase productivity by $100,000 per year. It will have annual
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operating costs of $30,000. Assume no salvage value at the end of ten years. The
companys required rate of return on projects like this is 15%.
C
0
to C
10
= expected cash flows for the project
C
0
= initial investment = 0
C
1
to C
3
= planning & engineering costs = $25,000
C
4
= capital investment = $200,000
C
5
to C
10
= cost savings operating costs = $100,000 - $30,000
= $70,000
r = companys required rate of return = 15%
2.2 NET PRESENT VALUE (NPV)
The net present value approach involves discounting the expected cash flows from each
year of the project. These cash flows are then summed to produce the projects present
value, hence the term net present value.
Acceptance Criteria: A project that produces a positive NPV is considered to be an
attractive investment opportunity.

) ( 25 . 37 $
) 15 . 1 (
70
) 15 . 1 (
70
) 15 . 1 (
70
) 15 . 1 (
70
) 15 . 1 (
70
) 15 . 1 (
70
) 15 . 1 (
) 200 (
) 15 . 1 (
) 25 (
) 15 . 1 (
) 25 (
) 15 1 (
) 25 (
0
r) (1
C
C NPV
10 9 8 7 6 5 4 3 2
n
1 t
n
n
0
thousands NPV
NPV

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RESULT: This is a good investment.
2.3 SIMPLE PAYBACK METHOD
The payback method is an ad hoc rule that looks at how quickly a project pays back the
original investment. In other words, when the NPV of the project is zero. It is sometimes
called the breakeven analysis because of when you finally pay off your investment and
start saving or making money.
The time period can be calculated quickly by constructing an NPV table like the one
shown above. Notice that for this project, the payback period is 8 years (C
8
= 50).

Acceptance criteria: In general, the shorter the payback period, the more desirable the
project, particularly when there is a great deal of uncertainty.

n
t
n
n
r
C
C
1
0
) 1 (
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RESULT: Some companies have aggressive payback requirements, such as a maximum
of two or three years to break even. With a payback of 8 years, this may be considered a
marginal or poor investment
2.4 PROFITABILITY INDEX (PI)
Closely related to NPV, PI compares the discounted cash inflows to the discounted cash
outflows.
Acceptance criteria: Projects with an index greater than 1 are generally considered to be
attractive investment opportunities.

RESULT: This is a favorable investment
2.5 INTERNAL RATE OF RETURN (IRR)
Rather than specifying a discount rate, IRR calculates the rate of return that project is
expected to yield over its lifetime. IRR is also know as the discount rate or breakeven
point that makes the project NPV equal to zero. This method takes a little bit more effort
to solve because it must be iterated for various values of IRR until the equation is solved.
However, it is a much better indication of the value of the investment.
Acceptance Criteria: A project with an IRR greater than the companys rate of return is
a good investment opportunity.
1.33 PI
.15) (1
(25)
.15) (1
(25)
.15) (1
(25)
) 15 1 (
) 25 (
.15) (1
70
.15) (1
70
.15) (1
70
.15) (1
70
.15) (1
70
.15) (1
70
PI
) outflows cash d (discounte inflows) cash discounted ( PI
4 3 2
10 9 8 7 6 5

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RESULT: While return on investment is made on this project, this may not be suitable to
meet a companys internal requirements.
3. GENERATING THE DATA TO USE FOR JUSTIFICATION
It is important to quantify the improvements that have been made using a justified
calculation, because these potential savings are sometimes challenging to quantify
because of the fuzzy nature of the savings. This is a good chance to show the creativity
in the work, but failing to show important values can limit the ability to justify the
projects.
Consider these savings when a cost justification is undertaken.
Improve product quality and yield.
Quality Improvement is on increasing the effectiveness of activities and processes to
provide added benefits to both the organization and its customers, this also increases the
yield of the organization and attracts new customer.
Lower manufacturing costs.
Reducing manufacturing costs increases profitability by making more with what you
have or the same with less. Some of the measures for lowering manufacturing costs are
reducing Reduce product rework effort.
11% IRR
0) equation this solve to IRR of values arious through v (iterate
IRR) (1
(-25)
....
IRR) (1
(-25)
IRR) (1
(-25)
IRR) (1
(-25)
IRR) (1
(-25)
IRR) (1
(-25)
IRR) (1
(-25)
0 NPV
0 NPV
10 6 5 4 3 2

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This reduction in rework time can be enabled by the generation of clear, agreed,
measurable desired business outcomes that are used to drive all dimensions of the project.
These clear and very specific outcome statements ensure clarity of direction and avoid
false starts or misalignments.
Increase manufacturing capacity.
Capacity is often defined as the capability of an object, whether that is a machine, work
center or operator, to produce output for a specific time period, which can be an hour, a
day, etc. Many companies ignore the measurement of capacity, assuming that their
facility has enough capacity, but that is often not the case.
Reduce the design-to-market cycle time.
When developing products, an entrepreneur, startup, inventor or small business can rarely
assume that the market will wait or that a competitor will not introduce something
smaller, better, faster, and at a lower price point. Therefore, reducing Design time-to-
market is a key requirement for business success and can be a competitive advantage for
those that do it right. Downtime through awareness, reducing wastage and reducing
changeover time.
Reduce inventory levels.
Inventory is the collection of unsold products waiting to be sold. Inventory is listed as a
current asset on a company's balance sheet. Reducing the amount of unsold items is
called reduce inventory level.
Reduce, control, and track Work In Process.
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Efficient decision making in a manufacturing environment requires the availability of
high quality data in real-time. Any initiative that strives to improve manufacturing costs,
reduce cycle time and demonstrate process compliance starts with this same fundamental
requirement. The Product WIP Tracking, Route Control and Traceability software
module is a tool that is specifically designed to provide work in progress (WIP) visibility
throughout the factory, validate the process flow, and provide the history of the process
steps accomplished on a product.
Improve control of process (simplify, lower, modify)
Understanding processes so that they can be improved by means of a systematic approach
requires the knowledge of a simple kit of tools or techniques. The effective use of these
tools and techniques requires their application by the people who actually work on the
processes, and their commitment to this will only be possible if they are assured that
management cares about improving quality.
Reduce paper handling.
Is a work environment in which the use of paper is eliminated or greatly reduced. This is
done by converting documents and other papers into digital form. Proponents claim that
"going paperless" can save money, boost productivity, save space, make documentation
and information sharing easier, keep personal information more secure, and help the
environment.
Reduce produce design and build time.
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Is the process of managing the entire lifecycle of a product from inception, through
design and manufacture, to service and disposal. PLM integrates people, data, processes
and business systems and provides a product information backbone for companies and
their extended enterprise.
Reduction of scrap values and scrap rates.
The worth of a physical asset's individual components when the asset itself is deemed no
longer usable. The individual components, known as "scrap," are worth something if they
can be put to other uses. Sometimes scrap materials can be used as is; other times they
must be processed before they can be reused. An item's scrap value is determined by the
supply and demand for the materials it can be broken down into.
Reduction of plant overhead charges.
An accounting term that refers to all ongoing business expenses not including or related
to direct labor, direct materials or third-party expenses that are billed directly to
customers. Overhead must be paid for on an ongoing basis, regardless of whether a
company is doing a high or low volume of business. It is important not just for budgeting
purposes, but for determining how much a company must charge for its products or
services to make a profit.
Increase manufacturing producibility.
The work has also identified gaps and opportunities for improvements, and suggested an
approach for next step in order to increase producibility in manufacturing of aerospace
engine components.
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Eliminate redundant data entry & storage.
Data redundancy leads to data anomalies and corruption and generally should be avoided
by design. Database normalization prevents redundancy and makes the best possible
usage of storage. Proper use of foreign keys can minimize data redundancy and chance of
destructive anomalies
Improve data access.
Data access typically refers to software and activities related to storing, retrieving, or
acting on data housed in a database or other repository. There are two types of data
access, sequential access and random access.
Lower operational costs.
Expenses associated with administering a business on a day to day basis. Operating costs
include both fixed costs and variable costs. Fixed costs, such as overhead, remain the
same regardless of the number of products produced; variable costs, such as materials,
can vary according to how much product is produced.
Delivery of products on time.
On time Delivery of the projects plays a vital role in the development of an organization,
it would avoid the unnecessary charges due to delay, it would also improve the reputation
of the organization in the market for its on time delivery without any defects.
Lower inspection costs.
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With the Inventory cost being high and adding to that having inspection cost also to be
high, it is obvious that the organization would shell out lot of money, hence lowering the
inspection cost would add up as an advantage, but we also need to make sure that the
standard of inspection should also be held high.
3.1 GENERATING THE DATA TO USE IN JUSTIFICATIONS
We also need to consider these Potential Gain Costs also while doing the Quantified
Justification.
Increased equipment and system support costs (adding robots will require adding
programming skills).
Qualified Repair & Maintenance requirements.
Higher training costs.
System modification costs.
Higher documentation costs.
Higher equipment tooling costs
4. ASSESSMENT CRITERIA
Payback period
Militate against any investment where the build-up of profits is relatively slow,
even though the eventual return may be high.

Return on investment(ROI)
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Average profit per year for the life of the projects over the average investment
employed. Between the less risky project where the profits are earned in the early years
of a project and one with the later earnings.
Discounted cash flow
The principle is the cash flows in the future are always worth less than the same
cash flow today. The Net Present Value (NPV) of a project is obtained by using a
discounted rate to bring present and future cash flows back to today's value. If it is
positive, the project would be acceptable if the discount rate chosen reflected the cost of
capital for this project, taking account of the project risk. Allowances are normally made
for taxation, depreciation allowances etc. A further refinement is to determine the NPVs
at a number of given discount rates and find the discount rate at which the NPV is 0. This
is the Internal Rate of Return (IRR) and can be seen as the rate at which the projects will
earn money for the firm. Internal hurdle rate which it will have to exceed for the project
to be acceptable.
5.ANNUAL OPERATION CASH FLOW FROM A FLEXIBLE MANUFACTURING
SYSTEM
Potential benefits of investment in flexible manufacturing capability gives the
investor the opportunity to capture future operational benefits with additional investment
pending positive market development, it is appropriate to evaluate such potential benefits
of a flexible manufacturing system with real options analysis.

Example:- Considering investment, sale revenue, market demand for different types of
products, unit selling price, fixed cost, variable cost, setup cost, equipment depreciation,
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and any possible salvage value after gain tax, the annual cash flow from production in
year i can be expressed as follows


And f
m
is the index variable related with market demand for product type m: f
m=1

if product m is in demand and will be produced by the flexible manufacturing system in
year i; and f
m=
0 if product m is not going to be produced in year i
FC(i) = Fixed cost of production in year i



OH(i) = Overhead cost in year i
DEP(i) = Depreciation of machines and equipment in year i .
SV(i) = Net salvage value of in year i after gain tax
I(i) = Investment made in year i
Tr = Tax rate for the investing company

For a given investment project in flexible manufacturing system, investment cost is
relatively easy to estimate given the detailed technical and financial planning for the
flexible manufacturing system by process design engineers and financial staff in close
M m i P i D f i RV
M
m
M
m
,... 2 , 1 ), ( ). ( ) ( RV(i)
Where,
I(i) - DEP(i) Tr) - (1 SV(i)] DEP(i) - STC(i) - OH(i) - VC(i) - FC(i) - [RV(i) CF(i)
m
1
m m
1
m







M
1 m
m
1
m m m
) ( ). ( ) ( VC VC(i) i UVC i D f i
M
m

M
1 m
) ( STC . STC(i) i f
m m
Page | 20

cooperation with technology and machine suppliers, it is assumed that demand and unit
selling price for product m in any given year D
m
and P
m
satisfy the following two
differential equations.

6. THE IMPACT OF CHANGES IN FOREIGN EXCHANGE RATE ON
INVESTMENT PROJECT EVALUATION WITH REAL OPTIONS ANALYSIS
In real options evaluation of financial investment in foreign countries, real option value
of the investment project could be affected by changes in foreign exchange rate, mostly
because of the fact that changes in foreign exchange rate will affect estimated operation
cash flows and project value, as well as initial investment and expansion investment.
Three regression models are developed to project possible trends of future exchange rate
movement:
The linear model.
The second order polynomial model.
The third order polynomial model.
The Linear Model
The mathematical model for a linear representation of the changes in exchange rate over
time is
Y= 0.0390 x - 0.0075
dz dt
P
dP
dz dt
D
dD
Pm Pm
m
m
Dm Dm
m
m
. .
. .




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Fig: Linear Model of Historical Exchange Rate between USD and CNY
Where Y is the accumulative change in US Dollar per Chinese Yuan since January 2005,
x represents time in years since the beginning of 2005. A graphic representation of this
model is shown in Figure 7.7. Based on the linear model projection, exchange rate
between US Dollar (USD) and Chinese Yuan (CNY) at the end of 2015 will be
approximately 0.1670 USD per CNY, or 5.9880 CNY per USD, verse 8.2781 CNY per
USD at the beginning of 2005
The Second Order Polynomial Model
Similarly, a second order polynomial model can be obtained as follows, with the same notation
and covers the same period of historical data. A graphic representation of this model is shown in
Figure
Based on the second order model, an exchange rate of 0.2357 USD per CNY, or 4.2430
CNY per USD could be expected by the end of 2015 if the second order trend of Chinese
Yuan appreciation during the last three years since 2005 continues through 2015.
Y = 0.0083x
2
+ 0.0142x + 0.0008

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Fig: 2
nd
Order Model of Historical Exchange Rate between USD and CNY
The Third Order Polynomial Model
With the same set of historical exchange rate data, a third order regression model can be
developed as follows:

The projection from this third order model indicates an even faster appreciation of
Chinese Yuan against US Dollar in the future years. An exchange rate of 0.4258 USD per
Chinese Yuan, or 2.3484 CNY per USD could be expected by the year of 2015 if theprojection
of the 3rd order model holds true until year 2015.
In order to select a reasonable regression model to estimate accumulative changes in
exchange rate, the following major factors must be considered: a) The data set that was used to
generate the regression models are relatively small with only 3 years of historical data, as
compared to the whole project life of 8 years; b) The fast appreciation of Chinese Yuan against
major foreign currencies, including the US Dollar, in the last 3 years, is based on the fact that the
exchange rate of CNY against major foreign currencies has not changed much for a long time
from the 1990s until 2005. The changes in exchange rate during the last three years is partially
Page | 23

due to trade and economic policy discussions and dialogue between Chinese and US government
agencies; c) The fast rate of appreciation of CNY against major foreign currency in the last three
years is not likely to continue long into the future, this rate of appreciation could slow down in
the future; d) For the economic evaluation of industrial investment project in China by an US
company, the selection of an exchange rate projection model where Chinese Yuan appreciates
too quickly against the USD well into the long future will largely and perhaps unrealistically
boost the operation cash flows generated by such an investment project when annual operation
cash flows are translated from Chinese Yuan into the US dollar, leading to risky investment
decisions.
Y= 0.0026x
3
0.0034x
2
+ 0.0265x

Fig: 3
rd
Order Model of Historical Exchange Rate Between USD and CNY



Page | 24

6.1 MAJOR FACTORS AFFECTING THE REGRESSION MODELS
In order to select a reasonable regression model to estimate accumulative changes in
exchange rate, the following major factors must be considered:
1. The data set that was used to generate the regression models are relatively small with
only 3 years of historical data, as compared to the whole project life of 8 years.
2. The fast appreciation of Chinese Yuan against major foreign currencies, including the US
Dollar, in the last 3 years.
3. The fast rate of appreciation of CNY against major foreign currency in the last three
years is not likely to continue long into the future, this rate of appreciation could slow
down in the future.
4. The selection of an exchange rate projection model where Chinese Yuan appreciates too
quickly against the USD and perhaps unrealistically boost the operation cash flows
generated by such an investment project when annual operation cash flows are translated
from Chinese Yuan into the US dollar, leading to risky investment decisions.
Table: Impact of Changes in Exchange Rate on Investment Requirements and Operation
Cash Flows

Page | 25

Where:
ECF
i
= (1+e
i
) CF
i
= Exchange rate adjusted cash
inflow in year i
EI = (1+e
i
) I = Exchange rate adjusted initial investment
EX = (1+E
i
) X = Exchange rate adjusted expansion investment


j n
n
k
EX
EI
k
ECF
k
ECF
k
ECF
) 1 ( ) 1 (
...
) 1 ( ) 1 (
NPV
2
2 1

Page | 26

7. CONCLUSION
The Economic Status of an organization is basically signified by the roles played by
different Justification methods such as Net Present Value, Simple Payback Method,
Profitability index and Internal Rate of Return. Supporting these justification methods is
the Data Generation and the Criteria for Assessment such as Payback Period, Return of
Investment and Discounted Cash Flow.
Along with this the Evaluation of Annual Operation of Cash flow from FMS and Impact
of Foreign Exchange with help of Regression Models would provide a clear picture of the
Economic Status of the Organization.
This is how the Economic Justification of FMS would help an organization to know their
status in the Market.
8. REFRENCES
1) www.wikipedea.com
2)Engineering costs and production economics.
3)University of Wisconsin- Milwaukee , Milwaukee.
4)Guwahati university , Guwahati,India.
5)IEEE Transactions on engineering management, volume 38, Feb 1991
6)International Journal of CIM
7)www.google.com
8)FMS course pack and class lessons
9)International Journal of Operation and Production management.
10) Investopedia