Kuliah Ekonomi Teknik Kimia JTK FT UGM 2012

Introduction
Probability estimation assumed that all values of costs, expenses, revenues, economic lives, and acceptable rates of return were known with certainty. Sensitivity analysis is used to determine the effect of technical and economic parameters on the profitability of a project. The potential error of each parametric variable is examined, as well as its effect on the project.

Sensitivity analysis
Break even analysis The Strauss Plot Relative profitability plot Tornado plot

Break even analysis

Break-even plot for pricing alternatives.

A realistic break-even plot.

The Strauss Plot

Example: the Strauss plot

The Strauss plot

Relative probability plot

Tornado plot

Discussion of Sensitivity Analyses

Only one variable at a time can be studied. Interrelated variables such as fixed capital investment, maintenance, and other investment items in operating expenses and their effect upon one another cannot be represented correctly. Synergistic effects particularly with respect to marketing variables such as sale volume, selling price, market share cannot be taken onto account.

Uncertainty analysis
To estimate the probability of a venture, one needs to take some assumptions. Each assumption has its own degree of uncertainty, and when taken together these uncertainties can result in large potential errors.

Estimates and Their Use in Economic Analysis

Example 10-1. Two alternatives are being considered. The best estimates for the various consequences are as follows: A B Cost $1000 $2000 Net annual benefit $150 $250 Useful life, in years 10 10 End-of-useful-life-salvage value $100 $400 If interest is 3.5%,which alternative has the better net present worth (NPW)?

Example 10-1.
Alternative A NPW = -1000+ 150(P/A, 3.5%,10) + 100(P/F, 3.5%,10) = -1000 + 150(8.317) + 100(0.7089) = -1000 + 1248+ 71 =+$319 Alternative B NPW = -2000 + 250(P/A, 3.5%, 10) + 400(P/F, 3.5%, 10) = -2000 + 250(8.317) + 400(0.7089) = -2000 + 2079 + 284 = +$363 Alternative B, with its larger NPW, would be selected.

Example 10-2.
Suppose that at the end of 10years, the actual salvage value for B were $300 instead of the $400 best estimate. If all the other estimates were correct, is B still the preferred alternative?

Revised B NPW = -2000 + 250(P/A, 3.5%, 10) + 300(P/F, 3.5%, 10) = -2000 + 250(8.317) + 300(0.7089) = -2000 + 2079 + 213 =+$292 A is now the preferred alternative.

A Range of Estimates
an optimistic estimate, the most likely estimate a pessimistic estimate

Example 10-3
A firm is considering an investment. The most likely data values were found during the feasibility study. Analyzing past data of similar projects shows that optimistic values for the first cost and the annual benefit are 5% better than most likely values. Pessimistic values are 15% worse. The firm's most experienced project analyst has estimated the values for the useful life and salvage value.
Optimistic Cost Net annual benefit Useful life, in years Salvage value $950 $210 12 $100 Most Likely $1000 $200 10 $0 Pessimistic $1150 $175 8 $0

Example 10-3

Compute the rate of return for each estimate. If a 10% before-tax minimum attractive rate of return is required, is the investment justified under all three estimates? If it is only justified under some estimates, how can these results be used.

Example 10-3
Optimistic Estimate PW of cost = PW of benefit $950 = 21O(P/A, IRRopt,12) + 100(P/F,IRRopt, 12) IRRopt = 19.8%

Most Likely Estimate $1000 = 200(P / A, IRRmostlikely,10) (P / A, IRRmostlikely,10) = 1000/200 = 5 IRRmostlikely = 15.1%
Pessimistic Estimate $1150 - 170(P/A, IRRpess,8) (P / A, IRRpess,8) = 1150/170 = 6.76 IRRpess= 3.9%

Example 10-3

From the calculations we conclude that the rate of return for this investment is most likely to be 15.1%, but might range from 3.9%to 19.8%.The investment meets the 10%MARRcriterion for two of the estimates. These estimates can be considered to be scenarios of what may happen with this project. Since one scenario indicates that the project is not attractive, we need to have a method of weighting the scenarios or considering how likely each is.

Example 10-4
Compute the mean for each parameter: Mean cost = [950 + 4 x 1000+ 1150]/6 = 1016.7 Mean net annual benefit = [210 + 4 x 200 + 170]/6 = 196.7 Mean useful life = [12 + 4 x 10+ 8]/6 = 10.0 Mean salvage life = 100/6 = 16.7 Compute the mean rate of return: PW of cost = PW of benefit $1016.7 = 196.7(P/A, IRRbeta,10) + 16.7(P/F,IRRbeta, 10) IRRbeta= 14.2%

Probability

Example 10-5
What are the probability distributions for the annual benefit and life for the following project? The annual benefit's most likely value is $8000 with a probability of 60%. There is a 30% probability that it will be $5000, and the highest value that is likely is $10,000. A life of 6 years is twice as likely as a life of 9 years.

Example 10-5
Probabilities are given for only two of the possible outcomes for the annual benefit. The third value is found using the fact that the probabilities for the three outcomes must sum to 1, 1 = P(Benefit is $5000) + P(Benefit is $8000) + P(Benefit is $10,000) P(Benefit is $10,000) = 1 - 0.6 - 0.3 = 0.1

The probability distribution can then be summarized Annual benefit $5000 $8000 $10,000 in a table. Probability 0.3 0.6 0.1

Example 10-5
The problem statement tells us: P(life is 6 years) = 2P(life is 9 years) P(6) + P(9)= 1 Combining these, we write 2P(9) + P(9) = 1 P(9) = 1/3 P(6) = 2/3 The probability distribution for the life is P(6) = 66.7% and P(9) = 33.3%.

Joint Probability Distributions

The project described in the previous example has a first cost of $25,000. The firm uses an interest rate of 10%. Assume that the probability distributions for annual benefit and life are unrelated or statistically independent. Calculate the probability distribution for the PW.

Example 10-6
Since there are three outcomes for the annual benefit and two outcomes for the life, there are six combinations. The first four columns of the following table show the six combinations of life and annual benefit. The probabilities in columns 2 and 4 are multiplied to calculate the joint probabilities in column 5. For example, the probability of a low annual benefit and a short life is 0.3 x 2/3, which equals 0.2 or 20%. The PW values include the $25,000 first cost and the results of each pair of annual benefit and life. For example, the PW for the combination of high benefit and long life is:

Example 10-6
Annual Benefit
$5,000 8,000 10,000 5,000 8,000 10,000 Probability 30% 60 10 30 60 10 Life 6 6 6 9 9 9 Probability 66.70% 66.7 66.7 33.3 33.3 33.3

Joint Probability
20.00% 40 6.7 10 20 3.3 100.00%

PW -3,224 9,842 18,553 3,795 21,072 32,590

Probability distribution function for PW

Expected Value

The first cost of the project in Example 10-5 is $25,000. Use the expected values for annual benefits and life to estimate the present worth. Use an interest rate of 10%.

Example 10-7
EVbenefit = 5000(0.3) + 8000(0.6) + 10,000(0.1) = $7300 EVlife = 6(2/3) + 9(1/3) = 7 years The PW using these values is PW(EV) = -25,000 + 7300(P/A, 10%,7) = -25,000 +6500(4.868) =$10,536

[Note: This is the present worth of the expected values, PW(EV), not the expected value of the present worth, EV(PW). It is an easy value to calculate that approximates the EV(PW), which will be computed using the joint probability

Example 10-8
Use the probability distributionfunction of thePWthat was derivedin Example 10-6 to calculate the EV(PW). Does this indicate an attractive project?

The table from Example 10-6 can be reused with one additional column for the weighted values of the PW (= PW x probability). Then, the expected value of the PW is calculated by summing the column of present worth values that have been weighted by their probabilities.

Example 10-8
Annual Probabilit Benefit y $5,000 8,000 10,000 5,000 8,000 10,000 30% 60 10 30 60 10 Life 6 6 6 9 9 9

Joint Probabilit Probabilit y y

Probabili ty 66.70% 20.00% -3,224 -$ 645 66.7 40 9,842 3,937 66.7 6.7 18,553 1,237 33.3 10 3,795 380 33.3 20 21,072 4,214 33.3 3.3 32,590 1,086 100.00% EV(PW) = $ 10,209

PW

PW x Joint

Example 10-8
With an expected PW of $10,209, this is an attractive project. While there is a 20% chance of a negative PW, the possible positive outcomes are larger and more likely. Having analyzed the project under uncertainty, we are much more knowledgeable about the potential result of the decision to proceed. The 10,209 value is more accurate than the approximate value calculated in Example10-7. The values differ because PW is a nonlinear function of the life. The more accurate value of $10,209 is lower because the annual benefit values for the longer life are discounted by 1/(1 + i) for more year.

Example 10-9
A dam is being considered to reduce river flooding. But if a dam is built, what height should it be? Increasing the dam's height will (1) reduce a flood's probability, (2) reduce the damage when floods occur, and (3) cost more. Which dam height minimizes the expected total annual cost? The state uses an interest rate of 5% for flood protection projects, and all the dams should last 50 years.

Example 10-9
Dam Height (ft) No dam 20 30 40
First Cost $0 700,000 800,000 900,000

Annual P (flood) x Height 0.25 0.05 0.01 0.002

Damages If Flood Occurs $800,000 500,000 300,000 200,000

Example 10-9

The easiest way to solve this problem is to choose the dam height with the lowest equivalent uniform annual cost (EUAC). Calculating the EUAC of the first cost requires multiplying the first cost by (A/P, 5%, 50). For example, for the dam 20ft high this is 700,000(A/P,5%, 50)= $38,344. Then the EUAC of the first cost and the expected annual flood damage are added together to find the total EUAC for each height. The 30 ft dam is somewhat cheaper than the 40 ft dam.

Example 10-9
Dam height (ft) No dam 20 30 40 EUAC of first cost $0 38,344 43,821 49,299 Expected annual flood damages $200,000 25,000 3000 400 Total Expected EUAC $200,000 63,344 46,821 49,699

Risk
Risk can be thought of as the chance of getting an outcome other than the expected value with an emphasis on something negative. One common measure of risk is the probability of a loss (see Example 10-6). The other common measureis the standard deviation (a), which measures the dispersion of outcomes about the expected value

Example 10-13

Using the probability distribution for the PW from Example 10-6, calculate the PW's standard deviation.

Example 10-13
Joint Annual Probab Probabilit Life Probabil Benefit ility y ity $5,000 30% 6 66.70% 20.00% 8,000 60 6 66.7 40 10,000 10 6 66.7 6.7 5,000 30 9 33.3 10 8,000 60 9 33.3 20 10,000 10 9 33.3 3.3 100.00%
PW x PW2 x

PW

-3,224 9,842 18,553 3,795 21,072 32,590

Probabili ty -$ 645 3,937 1,237 380 4,214 1,086 10,209

Probability
$ 2,079,480

38,747,954

22,950,061 1,442,100 88,797,408 35,392,740 189,409,745

Risk Versus Return

Example 10-14 A large firm is discontinuing an older product, so some facilities are becoming available for other uses. The following table summarizes eight new projects that would use the facilities. Considering expected return and risk, which projects are good candidates? The firm believes it can earn 4% on a risk-free investmenting government securities (labeed as project F).

Example 10-14
Project 1 2 3 4 5 6 7 8 F IRR 13.10% 12 7.5 6.5 9.4 16.3 15.1 15.3 4 Standard Deviation 6.50% 3.9 1.5 3.5 8 10 7 9.4 0

Example 10-14

Answering the question is far easier if we use Figure 10-7.Since a larger expected return is better, we want to select projects that are as "high up" as possible. Since a lower risk is better, we want to select project that are as "far left" as possible. The graph lets us examine the trade-off of accepting more risk for a higher return.

Example 10-14
efficient frontier.

dominated projects.

Simulation
Example 10-15 ShipM4U is considering installing a new, more accurate scale, which will reduce the error in computing postage charges and save $250 a year. The scale's useful life is believed to be uniformly distributed over 12, 13, 14, 15,and 16 years. The initial cost of the scale is estimated to be normally distributed with a mean of $1500 and a standard deviation of $150. Use Excel to simulate 25 random samples of the problem and compute the rate of return for each sample. Construct a graph of rate of return versus frequency of occurrence

Example 10-15
250 Min Max Iteration 1 2 3 4 5 25 Annual savings Life First Cost 12 1500 16 150 Mean Std dev IRR 14% 18% 14% 17% 12% 15%

15 13 12 14 13 14

1510 1217 1391 1297 1621 1408

Example 10-15
IRR vs Frequency
5 4 4 3 Frequency 3

2 2
1 1 0 8% 9% 10% 11% 12% 13% IRR 14% 15% 16% 17% 18% 19%

Example 10-16

Consider the scale described in Example 10-15. Generate 10,000 iterations and construct a frequency distribution for the scale's rate of return.

10-16