IEDA 3230: Engineering Economy

Investment under uncertainty

Agenda

- Different types of decision problems in engineering

economics where (a subset of) data is not
deterministic
- Problems where even probability distribution is
unknown (previous lecture)
- Problems where probability distribution of non-
deterministic parameters is known (this lec
onwards)
Agenda (this lecture)

Sources and characterization of randomness:

Cash flow for any time period is not known with certainty
The useful life of a project is not with certainty
The interest rate is not known with certainty
BUT
we may have estimates of the probability density functions

Objective:
To estimate the mean of PW, AW or FW
The variance of PW, AW or FW
The probability that PW (respectively, AW, FW) < 0

Decision criteria based on:

- The expected value
- The expected value, variance
- The expected value, variance, probability of some events
Motivating example (1)

A company discovers an off-shore oil reserve, and is considering whether

to invest in building an off-shore oil drilling rig, and when.

Concerns:
- Oil price fluctuations  how do we determine the present worth?
- Interest rates fluctuate  Build now or build later?
- Total amount of oil in the reserve is uncertain

If oil prices fluctuate a lot, is it better to delay developing the rig?

Motivating example (2)

Hong Kong Electric's Lamma Island power plant burns coal

and natural gas to generate electricity.
They are considering whether to invest in "scrubbers" to
reduce the impact of emissions.

The alternative is delay the installation, and pay for

environmental impact (e.g. by buying tradable emissions
allowances from free market

- Prices of allowances fluctuate

- Interest rates fluctuate
Background: Random variables

In analysis, we often use variables to store the value of some

quantity of interest (could be scalar, vector, …)

A random variable stores the value of something whose value

varies unpredictably, e.g.

- Number of bad apples in a bag (a discrete random variable)

- Height of a person (continuous random variable)

We are interested in: Mean, Variance, Probability of an event

# bad apples (xi) 0 1 2 3 4

Probability, P(xi) 0.5 0.2 0.15 0.1 0.05

If price of a bag of 4 is $24, what is the expected price per apple?

Background: Random variables..
# bad apples (xi) 0 1 2 3 4
Probability, P(xi) 0.5 0.2 0.15 0.1 0.05

Mean of a discrete random variable = 

Definition: E[X] = Σi xi P(xi)
Example: E[X] = 0*0.5 + 1*0.2 + 2*0.15 + 3*0.1 + 4*0.05 = 1

Variance of a random variable = square of the Std Dev = 2

Definition: Var[X] = E[ (X − E[X])2 ] = E[X2] −(E[X])2
Example: Var[X] =
0.5(0-1)2 + 0.2(1-1)2 + 0.15(2-1)2+ 0.1(3-1)2 + 0.05(4-1)2 = 1.5

Probability of an event
Prob(X ≤ 1) = ).5 + 0.2 = 0.7

Important discrete distributions: Binomial, Poisson

 Background: Random variables...

Continuous random variables

Possible values are in an interval [a, b]
Described by a probability density function, pdf = f (x),

Examples
Uniform distribution: Z ~ U[a,b]
Normal distribution: Z ~ N(μ, σ2)
Chi-square distribution: Z ~ (x)

Uniform Normal Chi-square

Functions of random variables

Some random variables may be modeled as a composition of

some other ones
e.g.:
- the total income of a family
- the total number of hours of TV watched in a house

If X and Y are independent, and Z = aX + bY

Mean: E[Z] = E[aX + bY] = aE[X] + bE[Y]
Variance: Var[Z] = Var[aX + bY] = a2Var[X] + b2Var[Y]

Nonlinear Functions f (X) of random variables

Mean: E[ f (X) ] = f ( E[X] )? NO!
Example: E[ X2 ]≠(E[X])2
E[ XY ] ≠ (E[X]) (E[Y]), but
E[ XY ] = (E[X]) (E[Y]) if X and Y are independent
 Normal distribution: X ~ N(μ, σ2)

An important distribution  the Central Limit Theorem(s)

Mean = μ
Variance = σ2
Standard deviation = σ
Standard normal distribution Z ~ N(0, 1)
Scaling: If X ~ N(μ, σ2), then (X−μ)/σ ~ N(0,1) X = μ+ Zσ
Probability of an event
Prob (X < c) = Prob (μ+Zσ < c) = Prob(Z < (c−μ)/σ)

area under curve, -∞ < Z < 2

Z ~ N(0, 12)
X ~ N(μ, σ2)
Normal distribution: X ~ N(μ, σ2)..

If X ~ N(10, 25), then X = 10+ 5Z

 Prob (X < 13.6) = Prob (Z < (13.6−10)/5)
= Prob( Z < 0.72) = 0.7642
Prof (X > 8) = 1 − Prob (X < 8) = 1 − Prob (Z < (8−10)/5)
= 1 − Prob (Z < − 0.4) = 1 − 0.3446 = 0.6554
Z ~ N(0, 1)
Properties of normal distribution

If X1 ~ N(μ1, σ12) , X2 ~ N(μ2, σ22), and X1 and X2 are

independent, then
The sum: X1+X2 ~ N(μ1+μ2, σ12+σ22)
The difference: X1−X2 ~ N(μ1−μ2, σ12+σ22)

If X1,X2,…,Xn are independent and n is large, then the

sum k1X1+k2X2+…+knXn approximates to normal
distribution, N(μ, σ2), with
Mean μ =k1E[X1]+k2E[X2]+…+knE[Xn]

Variance σ2 =k12Var[X1]+k22Var [X2]+…+kn2Var [Xn]

Independent investments with uncertain costs, AW method

A company is selecting between three alternative electrical

circuit protector for their factory

If the circuit protector fails, there will be a repair cost of 80,000

with probability 0.65, or 120,000 with probability of 0.35

All alternatives have useful life = 8 years; MARR = 12%

Which is the least expected cost alternative using the AW rule?

Alternativ Fixed Annual Probability of loss in a given year
e Cost maintenance
A 90,000 9000 0.4
B 100,000 10000 0.1
C 160,000 16000 0.01
 Independent investments with uncertain costs (cont.)

Points to consider:
- Is the probability of loss related to the probability of cost?
[we shall assume they are independent in this example]
- If an alternative fails in some year, does it change the
probability that it fails in a future year?
[in this case, no; therefore we can use the AW of capital]

Expected value of loss = Cfail = 0.65*80000 + 0.35*120000 = 94,000

Alt. AW of Capital Probability of loss Annual Cfail Total expected

CF(A/P, 12%, 8) in a given year Maint. equivalent
annual cost
A 18,117 0.4 9000 94,000*0.4 = 37,600 64,717
B 20,130 0.1 10000 94,000*0.1 = 9400 39,530
C 32,208 0.01 16000 94,000*0.01 = 940 49,148
Comparing alternatives, correlated random variables

When random variables are not independent, we may account

for probabilities by separating the outcomes into mutually
exclusive ones
Example: If the profit of a restaurant (CF = 1000) depends on
the profit in the previous year
- $1000

0.3 0.5 0.2

$460 $500 $580

0.5 0.2 0.3 0.1 0.8 0.1 0.4 0.3 0.3

$600 $650 $760 $680 $720 $770 $800 $960 $1000

 Comparing alternatives, correlated random variables (cont.)

When random variables are not independent: probability tree

can decompose the outcomes into mutually exclusive ones.

Calculating the expected PW of alternatives (MARR = 12%):

Comparing alternatives, correlated random variables (cont.)

Variance (PW) = E[ PW2] − (E[PW])2 = 13671

Standard deviation (PW) = (13671)0.5 = 117

Too risky comparing to mean = 39 [Why?]

What is the probability that the project cannot earn money?

Prob( PW<0) = 0.05 + 0.06 + 0.15 = 0.26

What is the probability that the IRR of the project is less

than MARR?
 Project life is a random variable

A shopping mall is considering to update its Air-circulation

(HVAC) system. The new system will cost $521,000. It is more
efficient, so it will save costs, and also lead to higher rental
income from shops ( increase profits = $79,600). It's projected
life can vary between 12 and 18 years.
Useful life (N) 12 13 14 15 16 17 18
Probability 0.1 0.2 0.3 0.2 0.1 0.05 0.05
PW -27926 -9689 6605 21148 34130 45720 56076

Note: PW = -521,000 + 79,600 ( P/A, 12%, N)

E(PW) = 0.1(-27926) + 0.2(-9689) + … + 0.05(56076) = $9,984

What is the Var(PW)? StDev(PW) ?

Hint: V(PW) = E[PW2] – E[PW]2
Annual cash flow is a continuous random variable

So far we have assumed that we can estimate the cash

flow for the project that we were evaluating.
In real life, we may only have some estimate
For now let's assume that the annual cash flows of a
project are each estimated by a random number from
independent normal probability distributions
- This assumption is not very realistic, but it will set us
up for future analysis
- Independence allows us to estimate E(PW), V(PW)
and StDev(PW) easily
Present Worth of Cash Flow (continuous, random, independent)
End of Year, K Expected value of Net cash flow, Fk SD of Net cash flow, Fk
0 -7000 0
1 3500 600
2 3000 500
3 2800 400

Assume: cash flow is a random variable from N(Fk, SD2),

MARR = 15%
PW = F0 + F1(P/F,i%,1) + … + Fn(P/F,i%,n)
E[PW] = E[F0] + E[F1](P/F,i%,1) +…+ E[Fn](P/F,i%,n)
= -7000 + 3500(P/F, 15%, 1) + …+ 2800(P/F, 15%, 3)
= 153
Var[PW] = Var[F0] + Var[F1](P/F,i%,1)2 +…+ Var[Fn](P/F,i%,n)2
= 0212 + 6002(P/F, 15%, 1)2 + …+ 4002(P/F, 15%, 3)2
= 484324 = 6962
 Present Worth of Cash Flow (continuous, random, independent)

In this case, the PW is itself a Normally distributed random variable

[Why?]

PW = N( 153, 6962)

What is the probability that the PW < 0?

Prob(PW<0) = Prob(Zσ +μ < 0)

= Prob(Z < −μ /σ) = Prob( Z < 153/696)
= Prob(Z < −0.22)
= 0.4129
Profit is a linear combination of two independent random vars

Suppose that the net annual cash flow, Fk, is a linear

combination of the revenues (Xk) and the costs (Yk)

Assume that Xk and Yk are independent random

variables
End of Year Net cash flow Expected Value Standard Deviation (SD)
K Fk = akXk + bkYk Xk Yk Xk Yk
0 X0+Y0 0 −100000 0 10000
1 X1+Y1 60000 −20000 4500 2000
2 X2+2Y2 65000 −15000 8000 1200
3 2X3+3Y3 40000 −9000 3000 1000
4 X4+2Y4 70000 −20000 4000 2000
5 2X5+2Y5 55000 −18000 4000 2300

What is the E(PW)? V(PW)? SD(PW)?

 Profit is a linear combination of two independent random vars

Recall that if X, Y are independent random variables,

E[aX + bY] = aE[X] + bE[Y], and
Var[aX + bY] = a2Var[X] + b2Var[Y]
End of Year E[Fk] = Var[Fk] =
K Fk akE[Xk] + bkE[Yk] ak2Var[Xk] + bk2Var[Yk]
0 F0 0 – 100000 = -100000 0 + 12*100002 = 100x106
1 F1 60000 – 20000 = 40000 45002 + 12*20002 = 24.25x106
2 F2 65000 – 2*15000 = 35000 80002 + 22*12002 = 69.76x106
3 F3 2*40000 – 3*9000 = 53000 22*30002 + 32*10002 = 45x106
4 F4 70000 – 2*20000 = 30000 40002 + 22*20002 = 32x106
5 F5 2*55000 – 2*18000 = 74000 22*40002 + 42*23002 = 85.16x106
E[PW] =−100000 + 40000(P/F,20%,1) +… = $32517
Var[PW] = 100*106 + 24.25*106(P/F,20%,1)2 + …= 186.75*106
So, PW~N(32517,136662) where 13666 = (186.75*106)0.5
Prob(PW < 0)=Prob(Z < −32517/13666) = Prob(Z<−2.3794)
Summary

- We studied some simple probabilistic models of project economics

- Assumed that the factors of interest (costs, revenues) are independent

Acknowledgements:
1. Lecture notes (IELM 3230), Prof Xiangtong Qi
2. Chapters 2, 3: Engineering Economy by Sullivan, Wicks, Koelling

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