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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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ENGINEERING ECONOMICS ISE460SESSION 21
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Quiz Results
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ENGINEERING ECONOMICS ISE460SESSION 21
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Quiz Results
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ENGINEERING ECONOMICS ISE460SESSION 21
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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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ENGINEERING ECONOMICS ISE460SESSION 21
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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