University of Science and Technolgy of Southern Philippines

SENSITIVITY
ANALYSIS &
STAGED DECISIONS

GROUP 6 -CE2S
Atanacio - Bohol - Guantero - Jampayas - Salaga
 GROUP MEMBERS

Atanacio, Avegail Guantero, Randy Salaga, Donita

reporter reporter reporter

Bohol, Benz Jampayas, Cherry

reporter reporter
 1 Determining Sensitivity to Parameter

Sensitivity Analysis Using Three

2 Estimates

Estimate Variability and the Expected

3 Value
CONTENT
Expected Value Computations for
4 Alternatives

Stages Evaluation of Alternatives Using a

5
Decision Tree

6 Real Options in Engineering Economics

18.1
DETERMINING SENSITIVITY
TO PARAMETER VARIATION
18.1
DETERMINING SENSITIVITY
TO PARAMETER
VARIATION

Sensitivity analysis
determines how a measure of worth—PW, AW, FW, ROR, BC, or CER—is
altered when one or more parameters vary over a selected range of
values. Usually one parameter at a time is varied, and independence with
other parameters is assumed

Sensitivity Analysis is a financial model that determines how target

variables are affected based on changes in other variables known as
input variables. It is a way to predict the outcome of a decision given a
certain range of variables.
 EXAMPLE

Wild Rice, Inc. expects to purchase a new asset for automated rice handling.
Most likely estimates are a first cost of $80,000, zero salvage value, and a
cash flow before taxes (CFBT) per year t that follows the relation $27,000 −
2000t. The MARR for the company varies over a wide range from 10% to 25%
per year for different types of investments. The economic life of similar
machinery varies from 8 to 12 years. Evaluate the sensitivity of PW by varying
(a) MARR, while assuming a constant n value of 10 years, and (b) n, while
MARR is constant at 15% per year. Perform the analysis by hand and by
spreadsheet.
 Solution by hand

(a) varying MARR, while assuming a constant n value of 10 years

Given:
n = 10 years MARR = 10%, 15%, 20% & 25% (5% increments)
parameter = MARR

PW(10%) = -80,000 + 25,000 (P/A, 10%, 10) - 2000 (P/G, 10%, 10)
10
( 1 + 0.10)10 - 1 1
PW(10%) = -80,000 + 25,000 ( 0.10 ( 1 + 0.10)10 ) -
( 1 + 0.10) - 1 2000
0.10
( 0.10
-10) ( ( 1 + 0.10) 10)
PW(10%) = -80,000 + 153, 614.18 - 45,782.68
PW(10%) = $ 27,831
10
 Solution by hand

(a) varying MARR, while assuming a constant n value of 10 years

Given:
n = 10 years MARR = 10%, 15%, 20% & 25% (5% increments)
parameter = MARR

PW(10%) = -80,000 + 25,000 (P/A, 10%, 10) - 2000 (P/G, 10%, 10) PW(15%) = -80,000 + 25,000 (P/A, 15%, 10) - 2000 (P/G, 15%, 10)
10
10 ( 1 + 0.15) - 1 2000 ( 1 + 0.15)10- 1 1
( 1 + 0.10)10 - 1 1
PW(10%) = -80,000 + 25,000 ( 0.10 ( 1 + 0.10)10 ) -
( 1 + 0.10) - 1 2000
0.10
( 0.10
-10) ( )
( 1 + 0.10) 10
PW(15%) = -80,000 + 25,000 ( 0.15 (1 + 0.15) 10 ) - 0.15 ( 0.15 -10) ( ( 1 + 0.15) 10)

PW(10%) = -80,000 + 153, 614.18 - 45,782.68 PW(15%) = -80,000 + 125, 469.22 - 33, 958.95

PW(10%) = $ 27,831 PW(15%) = $ 11,510

PW(20%) = -80,000 + 25,000 (P/A, 20%, 10) - 2000 (P/G, 20%, 10) PW(25%) = -80,000 + 25,000 (P/A, 10%, 10) - 2000 (P/G, 10%, 10)
10 10
10 10 ( 1 + 0.25) - 1 2000 ( 1 + 0.25) -1 1
PW(20%) = -80,000 + 25,000 (
( 1 + 0.20) - 1
0.20 (1 + 0.20)10 ) -
2000
0.20 (
( 1 + 0.20)
0.20
-1
-10) (
1
( 1 + 0.20)10) PW(25%) = -80,000 + 25,000 ( 0.25 (1 + 0.25)10) - 0.25 ( 0.25 -10) ((1 + 0.25) ) 10

PW(20%) = -80,000 + 104, 811.80 - 25, 774.16 PW(25%) = -80,000 + 89, 262.58 - 19, 974.09

PW(20%) = $ - 962 PW(25%) = $ - 10, 712

Solution by hand

(b) varying n, while MARR is constant at 15% per year

Given:
MARR = 15% n = 8, 10 & 12 ( 2 years increments)
parameter = n

PW(15%) = -80,000 + 25,000 (P/A, 10%, 8) - 2000 (P/G, 10%, 8)

8
PW(15%) = -80,000 + 25,000 ( 0.15 ( 1 + 0.15)- 1 ) -
( 1 + 0.15) 2000
( ( 1 + 0.15) -1
-10) ( )
8
1
8 0.15 0.15
( 1 + 0.15) 8

PW(15%) = -80,000 + 112, 183. 04 - 24, 961.43

PW(15%) = $ 7, 221 for 8 years

PW(15%) = -80,000 + 25,000 (P/A, 10%, 10) - 2000 (P/G, 10%, 10)
10 10
( 1 + 0.15) - 1 ( 1 + 0.15) - 1 1
PW(15%) = -80,000 + 25,000 ( 0.15 ( 1 + 0.15) ) - 10
2000
0.15 ( 0.15 -10) ( ( 1 + 0.15) ) 10

PW(15%) = -80,000 + 125, 469.22 - 33, 958.95

PW(15%) = $ 11,510 for 10 years

PW(15%) = -80,000 + 25,000 (P/A, 10%, 12) - 2000 (P/G, 10%, 12)
12
( 1 + 0.15) 12- 1
PW(15%) = -80,000 + 25,000 ( 0.15 ( 1 + 0.15) ) - ( -10) ( ( 1 + 0.15) )
( 1 + 0.15) - 1 2000 1
12 12
0.15 0.15

PW(15%) = -80,000 + 135, 515.48 - 42,369.78

PW(15%) = $ 13, 145 for 12 years
PLOT OF

‘PW versus MARR’

and n for sensitivity
analysis

sensitive

insensitive
Solution by spreadsheet

(a) varying MARR, while assuming a constant n value of 10 years

Solution by spreadsheet

(b) varying n, while MARR is constant at 15% per year

Sensitivity analysis
graph of percent
variation from the
most likely estimates
Sample PW sensitivity to
hours of operation for
two alternatives
18.2
SENSITIVITY ANALYSIS
USING THREE ESTIMATES
18.2
SENSITIVITY ANALYSIS
USING THREE ESTIMATES

The concept of making three estimates for each parameter:

• Pessimistic
• most likely
• optimistic estimates

This approach allows us to study measure worth and alternative

selection sensitivity within a predicted range of variation for each
parameter. Usually the most likely estimate is used for all other
parameters when the measure of worth is calculated for one particular
parameter or one alternative.
 EXAMPLE
Columbus, Ohio needs to resurface a 3 kilometer stretch of highway. Knobel
Construction has proposed two methods of resurfacing. The first method is a
concrete surface for a cost of $1.5 million and an annual maintenance cost
$10,000. The second method is an asphalt covering with a first cost of $1 million
and a yearly maintenance of $55,000. However, Knobel requests that every
third year the asphalt highway be touched up at a cost of $75,000. The city
uses the interest rate of bonds, 6% on it's last bond issue, as the discount rate.

(a.) Determine the breakeven number of years of the two methods. If the city
expects an interstate to replace this stretch of highway in 10 years, which
method should be selected?

(b.) If the touch-up cost increases by $5,000 per kilometer every 3 years, is the
decision sensitive to this increase ?
SOLUTION:

(a) Use PW analysis to determine the breakeven n value.

PW of concrete = PW of asphalt
-1,500,000 -10,000(P/A,6%,n)=- 1,000,000 -50,000(P/A,6%,n)

Where j= 3,6,9,..., n. The relation can be rewritten to reflect the

incremental cash flows.
 SPREADSHEET SOLUTION

•Using the NPV function

At approximately n = 11.4 years,

concrete and asphalt resurfacing
break even economically. Since
the road is needed for 10 more
years, the extra cost of concrete
is not justified; select the asphalt
alternative.
SOLUTION:

(b) The total touch-up cost will increase by $15,000 every 3 years.

Now the breakeven n value is between 10 and 11 years—10.8 years

using linear interpolation . The decision has become marginal for
asphalt, since the interstate is planned for 10 years.
18.3
ESTIMATE VARIABILITY
AND EXPECTED VALUE
18.3
ESTIMATE VARIABILITY AND
EXPECTED VALUE

The expected value can be interpreted as a long-run average observable if the

project is repeated many times. Since a particular alternative is evaluated or
implemented only once, the expected value results in a point estimate. However,
even for a single occurrence, the expected value is a meaningful number

The expected value E ( X ) is computed using the relation

where
Xi value of the variable X for i from 1 to m different values
P (Xi ) probability that a specifi c value of X will occur
Probabilities are always correctly stated in decimal form, but
they are routinely spoken of in percentages and often referred to
as chance, such as the chances are about 10%.
 EXAMPLE
ANA airlines plans to offer several new electronic services on fl ights between Tokyo and selected European
destinations. The marketing director estimates that for a typical 24-hour period there is a 50% chance of
having a net cash fl ow of $5000 and a 35% chance of $10,000. He also estimates there is a small 5% chance of
no cash fl ow and a 10% chance of a loss of $1000, which is the estimated extra personnel and utility costs to offer
the services. Determine the expected net cash fl ow.

SOLUTION:

Let NCF be the net cash fl ow in dollars, and let P (NCF) represent the associated probabilities

E (NCF) =5000(0.5) + 10,000(0.35) + 0(0.05) - 1000(0.1)

= $5900
18.4
EXPECTED VALUE
COMPUTATIONS FOR
ALTERNATIVES
18.4
EXPECTED VALUE
COMPUTATIONS FOR
ALTERNATIVES

The expected value computation E ( X ) is utilized in a variety of ways. Two prime ways are to:

• Prepare information for use in an economic analysis.

• Evaluate the expected viability of a fully formulated alternative.
 EXAMPLE
There are many government incentives to become more energy-effi cient. Installing solar panels on homes,
business buildings, and multiple-family dwellings is one of them. The owner pays a portion of the total
installation costs, and the government agency pays the rest. Nichole works for the Department of Energy and is
responsible for approving solar panel incentive payouts. She has exceeded the annual budgeted amount of $50
million per year in each of the previous 2 years. Disappointed with this situation, Nichole and her boss decided to
collect data to determine what size increase in annual budget the incentive program needs in the future. Over
the last 36 months, the amount of average monthly payout and number of months are shown in Table 18–3 .
She categorized by level the monthly averages according to her experience with the program. Provided the
same pattern continues, what is the expected value of the dollar increase in annual budget that is needed to
meet the requests?
Use 36 months of payouts PO j ( j low, . . . ,very high) to estimate the probability P (PO j ) for each level,
and make sure the total is 1.0.

Level, j Probability of Payout Level, P (PO j )

Very high P (PO 1 ) = 15/36 = 0.417

High P (PO 2) = 10/36 = 0.278
= 1.000
Moderate P (PO 3 ) = 7/36 = 0.194
Low P (PO 4 ) = 4/36 = 0.111

The annual expected budget need is

E [PO] = 6.5(0.417) + 4.7(0.278) + 3.2(0.194) + 2.9(0.111)
E [PO] = 2.711 + 1.307 + 0.621 + 0.322
E [PO] = $4.961
12 x 4.961 million = $59.532 million.
The current budget of $50 million should
be increased by an average of
$9.532 million per year.
18.5
STAGED EVALUATIONS OF
ALTERNATIVES USING A
DECISION TREE
18.5
STAGED EVALUATION OF
ALTERNATIVES USING A
DECISION TREE

Alternative evaluation may require a series of decisions in which the outcome from
one stage is important to the next stage of decision making. When each alternative
clearly defined and probability estimates can be made to account for risk, it is
helpful to perform the evaluation using a decision tree.

A decision tree includes:

More than one stage of alternative selection.
Selection of an alternative at one stage that leads to another stage.
Expected results from a decision at each stage.
Probability estimates for each outcome.
Estimates of economic value (cost or revenue) for each outcome.
Measure of worth as the selection criterion, such as E(PW).
(a) Decision node (b) Probability node

(c) Tree structure

To utilize the decision tree for alternative evaluation and selection, the following additional information is
necessary for each branch:

The estimated probability that each outcome may occur. These probabilities must sum to 1.0 for each set of
outcomes (branches) that result from a decision.
Economic information for each decision alternative and possible outcome, such as initial investment and
estimated cash flows.

Decisions are made using the probability estimate and economic value estimate for each outcome
branch. Commonly the present worth at the MARR is used in an expected value computation
of the type in Equation. This is the general procedure to solve the tree using PW
analysis:

1. Start at the top right of the tree. Determine the PW value for each outcome branch considering the time
value of money.
2. Calculate the expected value for each decision alternative.
3. At each decision node, select the best E (decision) value—minimum cost or maximum value
(if both costs and revenues are estimated).
4. Continue moving to the left of the tree to the root decision in order to select the best alternative.
5. Trace the best decision path through the tree.
 EXAMPLE
A decision is needed to either market or sell a new invention. If the product is marketed, the
next decision is to take it international or national. Assume the details of the outcome branches
result in the decision tree of Figure 18–9 . The probabilities for each outcome and PW of CFBT
(cash fl ow before taxes) are indicated. These payoffs are in millions of dollars. Determine the
best decision at the decision node D1.

Solution

Use the procedure above to determine that the D1 decision alternative to sell the invention should maximize E (PW
of CFBT).
1. Present worth of CFBT is supplied.
2. Calculate the expected PW for alternatives from nodes D2 and D3, using Equation [18.3]. In Figure 18–9 , to the
right of decision node D2, the expected values of 14 and 0.2 in ovals are determined as

E(international decision) = 12(0.5) + 6(0.5) = 14

E(national decision) = 4(0.4) - 3(0.4) - 1(0.2) = 0.2

The expected PW values of 4.2 and 2 for D3 are calculated in a similar fashion.
 EXAMPLE
Solution

3. Select the larger expected value at each decision node. These are
14 (international) at D2 and 4.2 (international) at D3.
4. Calculate the expected PW for the two D1 branches.

E(market decision) = 12(0.2) + 4.2(0.8) = 6.16

E(sell decision) = 9(1.0) = 9

The expected value for the sell decision is simple since the one
outcome has a payoff of 9.
The sell decision yields the larger expected PW of 9.

5. The largest expected PW of CFBT path is to select the sell branch

at D1 for a guaranteed $9,000,000.
18.6
REAL OPTIONS IN
ENGINEERING ECONOMICS
18.6
REAL OPTIONS IN
ENGINEERING ECONOMICS

Staged funding Real Options Analysis

When the decision to invest more or less can be
delayed into the future. is the application of
techniques to determine the
economic consequences of
delaying the funding
Option decisions as allowed by the
is a purchase or investment that contractually provides option.
the privilege to take a stated action by some stated
time in the future, or the right to not accept the offer and Expand
forfeit the option
Continue as is
Abandon
Real Option
Replicate
is the investment (cost) in a project, process, or
system.
 EXAMPLE
A start-up company in the solar energy production business, SolarScale Energy, Inc., has developed and
field-tested a modularized, scalar solar thermal electric (STE) generation system that is relatively inexpensive to
purchase and has an efficiency considerably better than traditional photovoltaic (PV) panels. The technology is
promising enough that Capital Investor Funds (CIF) has provided $10 million for manufacturing. Additionally, a
contract with a consortium of sunbelt states has been offered, but not accepted thus far, for a total of $1.5 million
per year for a 2-year test period. By contract, the units will be marketed through the state energy departments
with all revenue going to the state treasuries. The lead engineer at SolarScale, the manager of CIF, and a
conservation representative for the state consortium have developed the following staged-funding options,
based on the delayed decision to increase manufacturing production level until preliminary results of the 2-year
contract are in hand

Develop the two-stage decision tree for the options
described.
EXAMPLE
The base case is the 1x production level with the 8-
year follow-on contract from the consortium. If the
estimates for this option are considered the most
likely (expected value) estimates, determine the
present worth at a MARR of 10% per year
PW(10%) =$ -10 M + $1.5 M (P/A, 10%, 10)
( )
10
( 1 + 0.10) -1
PW(10%) = $-10,000,000 + $ 1,500,000 0.10 ( 1 + 0.10) 10
PW(10%) = $ -783,149.34
 EXAMPLE
Identify the best economic option when the stage 2 funding decision must be made

Only the 2 x production-level

option is justified at MARR = 10%
per year. If SolarScale and CIF, the
financial backers, are not
convinced that the sales level will
exceed 5000 units per year, the
contract option should be
declined.
 CHAPTER SUMMARY

When two alternatives are compared, compute and graph the measure of worth
for different values of the parameter to determine when each alternative is
better.
When several parameters are expected to vary over a predictable range, the
measure of worth is plotted and calculated using three estimates for a
parameter—most likely, pessimistic, and optimistic.
Decision trees are used to make a series of alternative selections. This is a way to
explicitly take risk into account. Expected value computations are coupled with
those for the measure of worth to solve the tree and find the best alternatives
stage by stage.
Staged funding over time can be approached using the evolving area of real
options. Delaying an investment decision and considering the risks of the future
can improve the overall E (PW) of a project, process, or system.
REFERENCES

Leland Blank, P.E.

Texas a & M University
American University of Sharjah, United
Arab Emirates

Anthony Tarquin, P.E.

University of Texas at El Paso
THANK YOU