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DEALING WITH UNCERTAINTY SOURCES OF UNCERTAINTY

Four Major source of uncertainty


The motivation for dealing with risk and 1) Possible inaccuracy of the estimates used in
uncertainty is to establish the bounds of error in the study.
our estimates such that another alternative 2) Types of business involved in relation to the
being considered many turn out to be a better future health of the economy.
choice than the one we recommended under 3) Type of physical plant and equipment involved.
assumed certainty. 4) Length of the assumed study period.
ªAnnual income and expenses are discovered to be
the most sensitive elements in the study.
DECISIONS UNDER RISK – Those in which the
analysts models the decision problem in
terms of assumed possible future outcomes,
or scenarios, whose probabilities of COMMON NONPROBABILISTIC
occurrence can be estimated. METHODS FOR DEALING WITH
UNCERTAINTY
DECISIONS UNDER UNCERTAINTY –decision 1) BREAKEVEN ANALYSIS – commonly utilized
problems characterized by several unknown when the selection among alternatives is
futures for which probabilities of occurrence heavily dependent on a single factor, such
cannot be estimated. as capacity utilization, that is uncertain.

2) SENSITIVITY ANALYSIS – employed when


ªDetermine how sensitive a given investment is to one or more factors are subject to
changes in particular factors (parameters) that are uncertainty.
not known certainty.
3) OPTIMISTIC-PESSIMISTIC ESTIMATION –
used to establish a range of extreme
values for the economic measure of merit.
CE 22 Engineering Economy – Dealing with Uncertainty 1 CE 22 Engineering Economy – Dealing with Uncertainty 2
4) RISK-ADJUSTED MARR – utilized to deal with - Breakeven Point is the value of factor y for
estimation uncertainties; use of higher which the two EW’s are equal.
MARRs for alternatives that are classified
as highly uncertain and lower MARRs for EWA = EWB
projects with fewer uncertainties.
f1(y) = f2(y)
5) REDUCTION OF THE USEFUL LIFE – project
life is reduced by a fixed percentage and COMMON FACTORS
each alternative is evaluated regarding its (USUALLY CONSIDERED)
acceptability over only this reduced life
span. 1) REVENUE AND ANNUAL COSTS – solve for annual
revenue (or cost) required to equal (breakeven)
w/ annual costs (or revenue).
BREAKEVEN ANALYSIS 2) RATE OF RETURN – solve for the rate return at
- Through breakdown analysis, one can solve which two given alternatives are equally
desirable.
for the value of that factor at which the
conclusion is a stand-off (Breakeven Point) 3) SALVAGE VALUE – solve for the future resale value
- If one can estimate whether the actual that would result in difference as to preference
for an alternative.
outcome of the common factor will be higher
or lower than the breakeven point, the best 4) EQUIPMENT LIFE – solve for the useful life required
alternative becomes apparent. for an alternative to be justified

EWA = f1(y) and EWB = f2(y) 5) CAPACITY UTILIZATION – solve for the hours of
utilization per year, for example, at which an
alternatives are equally desirable.
EW = Equivalent worth value for net cash flow
y = a common factor of interest affecting the Mathematical
¾ Approach to
equivalent worth of alternatives A & B. Graphical
¾ solution

CE 22 Engineering Economy – Dealing with Uncertainty 3 CE 22 Engineering Economy – Dealing with Uncertainty 4
ª In breakeven analysis, project lives may or may a. Which alternative is more attractive:
not be equal, - care should be taken to determine b. What is the breakeven point of the project in
whether the coterminated or repeatability percentage of homes subscribing?
assumption best fits the situation.
In-House Cablex
Materials and $675,000 $615,000
equipment
Labor (one-time; $110,000 $145,000
Example of Breakeven Analysis installation)
Maintenance $30,000/year $42,000/year
A small-town cable TV company wishes to expand its
coverage into a rural area just east of town. A study
indicates that 3,000 homes will be within connecting 3000 homes within connecting range
range of the proposed cable system, and the company MARR = 15%
knows that the typical subscriber rate is 43% (i.e., 43% 43% subscriber rate
of the homes with the option to get cable TV actually do
so.). The basic charge is $20 per month, plus a one-time Basic charge - $20/month
$50 installation fee. The company must pay 3% of its One-time installation fee - $50
gross revenue to the city government and 20% of its Company must pay:
gross revenue to the program sources (e.g., HBO, Æ 3% of its gross revenue to the city government
Showtime). The company uses a 10-year planning Æ 20% to its gross revenue to the program sources.
horizon for this type of project (0 salvage value is 10 year planning horizon (zero salvage value)
assumed). The company’s present personnel can easily
service 2,000 new subscribers without having to use
overtime or hire new people. However, some additional Company’s present personnel can easily service 2000
overtime maintenance costs would be incurred. There is subscribers without having to use overtime or hire new
a choice between (a) using company people to install people. But additional overtime maintenance costs
and maintain the new lines, taps, and distribution would be increased.
amplifiers and (b) letting CABLEX, an outside company
which specializes in CATV installations and Choices:
maintenance, do the job for a fee. The company’s MARR
is 15%. (a) Using company people to install and maintain
the new lines, taps and distribution centers
(b) Letting CABLEX do the job for a fee
CE 22 Engineering Economy – Dealing with Uncertainty 5 CE 22 Engineering Economy – Dealing with Uncertainty 6
Determine: (b) Subscription :

0.77 X (50)(3000) + 0.77 X(3000)(20x12) 1 - 1.15-10


(a) Which alternative is more attractive? [ 0.15 ]
(b) What is the breakeven point of the project in
percentage of homes subscribing? = 2,897,905 X

In-House Cablex Breakeven Equation:


Materials and $675,000 $615,000
equipment -675,000 - 110,000 – 150,563 + 2,897,905X = 0
Labor (one-time; $110,000 $145,000
installation) X = 0.323 or 32.3% of homes subscribing
Maintenance $30,000/year $42,000/year

(a) Take the AW of all cash flows:


Investments: -675,000 -615,000
SENSITIVITY ANALYSIS
Labor/one time; installations: -110,000 -145,000
Sensitivity – the relative magnitude of change in
-10 -10
the measure of merit caused by one or more
Maintenance : - 30,000 [1-(1.15)
0.15 ] - 42,000
[1-(1.15)
0.15 ] ] changes in estimated study factor values.
= - $150,563 = - $ 210,788 ªthe relative magnitude of the change in one
or more factors that will reverse a decision
among alternatives.
Subscription: +0.77 (0.43)(3000)(50)
ªthe relative magnitude of the reverse a
(R-E): +0.77 (20x12)(0.43)(3000) 1-(1.15)-10 decision among alternatives.
[ 0.15 ]
= $1,246,099 provides information about the potential impact
¾
of uncertainty in selected factor estimates.
PW = $310,536
∴ In-House is the better alternative.

CE 22 Engineering Economy – Dealing with Uncertainty 7 CE 22 Engineering Economy – Dealing with Uncertainty 8
Example in Sensitivity Analysis (b) Life:
+50% → $ 72,230 -10% → $ 34,980
Investment $ 140,000 +40% → $ 67,653 -20% → $ 25,890
Annual Savings $ 25,000 +30% → $ 62,522 -30% → $ 15,698
Useful Life 12 years +20% → $ 56,769 -40% → $ 4,272
Market Value (SV) $ 40,000 +10% → $ 50,319 -50% → - $ 8,540
MARR 10%/year
Determine sensitivity of PW to ± 50% charges in the most likely estimates of:
a) Annual Savings
b) Life Present Worth, $
c) Market Value (SV) 140,000

120,000
Annual Savings
1 − (1 + 0.10)  −12

 + 40,000[1 + 0.10]
−12
PW = −140,000 + 25,000 
100,000
Life

 0.10  Market Value 80,000

PW = −140,000 + 25,000(6.813691) + 40,000(0.318631) 60,000

40,000
PW = + $ 43,088
20,000

(a) Annual Savings: (c ) Market Value: 0

+50% Æ $ 128,259 Æ $ 49,460 -60% -40% -20%


-20,000
0% 20% 40%
% Change in Parameter
60%

+40% Æ $ 111,224 Æ $ 48,186 -40,000

+30% Æ $ 94,190 Æ $ 46,911 -60,000

+20% Æ $ 77,156 Æ $ 45,637


+10% Æ $ 60,122 Æ $ 44,362
-10% Æ $ 26,053 Æ $ 41,813
-20% Æ $ 9,019 Æ $ 40,538
-30% Æ -$ 8,015 Æ $ 39,264
-40% Æ -$ 25,049 Æ $ 37,989
-50% Æ -$ 42,084 Æ $ 36,715

CE 22 Engineering Economy – Dealing with Uncertainty 9 CE 22 Engineering Economy – Dealing with Uncertainty 10
OPTIMISTIC – PESSIMISTIC Example in Optimistic-Pessimistic Analysis
ESTIMATES
For the estimates given below:
• Exploring sensitivity by estimating one or more
factors in a favorable (optimistic) direction and in Optimistic Most Likely Pessimistic
an unfavorable (pessimistic) direction to Investment $ 80,000 $ 95,000 $ 120,000
investigate the effect of these changes on study Useful Life 12 years 10 years 6 years
results. Salvage $ 30,000 $ 20,000 0
Value
OPTIMISTIC CONDITION/ESTIMATE Net Annual $ 35,000 $ 30,000 $ 20,000
• Value when things occur as well as can be Cash Flow
reasonably expected. MARR 12%/year 12%/year 12%/year

PESSIMISTIC CONDITION/ESTIMATE Problem:


• Value when things occur as detrimentally as can a) Determine AW of each estimate.
be reasonably expected. b) With useful life and net annual cash flow as the
most critical elements, Develop a table
• An effective way of displaying and examining showing the AW for all combinations of
sensitivity is to graph the measure of merit for estimates for these two factors. (All others
independent variation of all factors of interest by remain @ ML values)
expressing variation for each on a common
abscissa in terms of percent deviation from its Solution:
most likely value. a) Optimistic:

• Another type of sensitivity test that is often quite  0.12   0.12 


AW = −80,000 −12 
+ 30,000  + 35,000
valuable is to determine the relative (or absolute) 1 − 1.12  1.12 − 1
12
change in one or more factors that will just
reverse the decision. AW = +$ 23,328

CE 22 Engineering Economy – Dealing with Uncertainty 11 CE 22 Engineering Economy – Dealing with Uncertainty 12
RISK-ADJUSTED MINIMUM
ATTRACTIVE RATES OF RETURN
Most Likely:
• Manipulation of the MARR to account for
 0.12   0.12  uncertainty in estimates.
AW = −95,000  −10 
+ 20,000   + 30,000
1 −
 1.12  1.12
10
− 1  (i.e.) Increasing the MARR places emphasis on
AW = +$ 14,326. early cash flows rather than on longer-term
benefits, and this would appear to
compensate for time-related project
Pessimistic uncertainties.)

 0.12  DISADVANTAGES
AW = −120,000  −6 
+ 20,000
– often leads to an illogical recommendation
1 − 1.12 
AW = −$ 9,187 – cost only alternatives are made to appear more
desirable as the interest for uncertainty

b) – at high interest rates, the alternative with the


longest investment requirement would be
favored.
Useful Life
O ML P REDUCTION OF USEFUL LIFE
Net O $ 20,492 $ 19,326 $ 14,358
Annual ML $ 15,492 $ 14,326 $ 9,358 Dealing with uncertainty in an engineering
¾
Cash P $ 5,492 $ 4,326 $ 642 economy study tends to lead to the adoption of
Flow conservative (pessimistic) estimates of factors so
as to reduce downside risks of making a wrong
decision.

CE 22 Engineering Economy – Dealing with Uncertainty 13 CE 22 Engineering Economy – Dealing with Uncertainty 14
- Makes use of a truncated project life that is
often considerable less than the estimated
useful life.
- Heavy emphasis is placed on rapid recovery
of investment capital in the early years of a
project’s life.

CE 22 Engineering Economy – Dealing with Uncertainty 15