engineering economics ise460 session 21 chapter 12, july 2, 2014 geza p. bottlik page 1 outline...

ENGINEERING ECONOMICS ISE460SESSION 21

CHAPTER 12, July 2, 2014

Geza P. Bottlik Page 1

OUTLINE

• QUESTIONS?

• News?

• Quiz Results

• Go over quiz

• Go over Homework

• Recommendations

• CHAPTER 12 - RISK

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Quiz Results

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Quiz Results

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Quiz Results

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Recommendation

• We are down to the last week

– Farmer’s Market on Thursday, I had pasta, Barbara had

Vegetarian Indian – very good

– British Museum

» Sudanese Lyre right at the entrance, one small room,

featured holding of the Museum

» Room 38 Clocks

» Room 92 Japan

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Recommendations

• Science Museum (we spent 6 hours)

– Near V&A in Kensington

– Fabulous

» Computing, Mathematics, Space

• Tate Modern (we spent 3 hours)

– Development of 20th century art

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Recommendations

• From The Science Museum

– An artifact I was remotely involved in and also led to

meeting Barbara

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Risk

• Sensitivity Analysis

• Break Even Analysis

• Simulation

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INTRODUCTION

• ALL THINGS ARE SUBJECT TO VARIABILITY

– THIS INCLUDES PROJECT CASH FLOWS

• WHEN WE EVALUATE A PROJECT, WE ARE TRYING TO

PREDICT THE FUTURE

• TO PREDICT THE FUTURE, WE USE DATA FROM THE PAST

– THIS IS CALLED FORECASTING

• MOST COMMONLY, A FORECAST WILL PROVIDE AN

EXPECTED VALUE (THE AVERAGE) AND A STANDARD

DEVIATION, WHICH INDICATES THE POTENTIAL

VARIABILITY AROUND THE EXPECTED VALUE

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INTRODUCTION (CONTINUED)

• RISK – UNCERTAIN CASH FLOW, BUT WITH SOME KNOWLEDGE OF THE POTENTIAL PROBABILITY DISTRIBUTION

• MANY THINGS NEED TO BE ESTIMATED:

– TOTAL MARKET AND MARKET SHARE

– COST OF PRODUCTION

– SELLING PRICE THAT THE MARKET WILL BEAR

– LIFE

– TAX RATES

– ECONOMIC CONDITIONS

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INTRODUCTION (CONTINUED)

• EACH ITEM WILL HAVE A BEST ESTIMATE

– THIS IS NOT ENOUGH, AS IT DOES NOT INDICATE THE

LEVEL OF RISK

• RISK ANALYSIS – ASSIGNING PROBABILITIES TO

OCCURRENCES

• SENSITIVITY ANALYSIS (WHAT Ifs) REFERS TO

CALCULATING HOW MUCH THE PRESENT WORTH WILL

CHANGE IN RESPONSE TO AN INPUT VARIABLE

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BREAK EVEN ANALYSIS

• Break even means that the NPV is equal to zero at the

desired MARR

• If only one item is variable, we can use goal seek to find its

value when the NPV is zero

• When there are two or more items that vary we have to use

simulation

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PROBABILITY CONCEPTS

• RANDOM VARIABLE – A VARIABLE THAT CAN TAKE ON MORE

THAN ONE VALUE (EVERYTHING)

• RANDOM VARIABLES CAN BE DISCREET(e.g., INTEGERS) OR

CONTINUOUS

• PROBABILITY DISTRIBUTION – THE VALUES A RANDOM VARIABLE

CAN TAKE ON AND THE ASSOCIATED PROBABILITY

• OBJECTIVE PROBABILITY – BASED ON DATA (THERE IS A 13/52

PROBABILITY THAT A CARD I PULL FROM A DECK OF CARDS IS A

SPADE)

• SUBJECTIVE PROBABILITY – BASED ON OPINION (60%

PROBABILITY THAT THE STOCK MARKET WILL GO UP

TOMORROW)

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PROBABILITY CONCEPTS (CONTINUED)

• MODE – MOST FREQUENTLY OCCURING VALUE

• COMMON DISTRIBUTIONS USED IN ANALYSIS

– NORMAL

– UNIFORM

– TRIANGULAR

– BETA

– POISSON

– BINOMIAL

• CUMULATIVE DISTRIBUTION – PROBABILITY OF X < A GIVEN VALUE

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PROBABILITY CONCEPTS (CONTINUED

• EXPECTATION = MOST LIKELY VALUE = AVERAGE

• DISPERSION – THE AMOUNT THAT A VARIABLE VARIES

ABOUT ITS AVERAGE

– RANGE

– VARIANCE

– STANDARD DEVIATION

– MAD (MEAN AVERAGE DEVIATION)

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DISTRIBUTION OF NPW

• PROCEDURE

– NPW AS A FUNCTION OF RANDOM VARIABLES

– EACH RANDOM VARIABLE HAS ITS OWN DISTRIBUTION

– LOOK AT RELATIONSHIP AMONG THE RANDOM

VARIABLES

– EVALUATE MEAN AND STANDARD DEVIATION OF NPW

(NORMAL DISTRIBUTION)

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SIMULATION

• MONTE CARLO METHOD

– DEFINE A DISTRIBUTION FOR EACH VARIABLE

– USE RANDOM NUMBER GENERATION TO COME UP WITH A SPECIFIC VALUE FOR EACH VARIABLE

– CALCULATE THE RESULTING NPW

– REPEAT HUNDREDS OF TIMES

– CALCULATE MEAN AND STANDARD DEVIATION OF NPW: YOU ARE READY TO PREDICT PROBABILITY OF A GIVEN NPW

– See spreadsheet demo

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SIMULATION