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Engineering 90

Dr. Gregory Crawford

Four Ways to do Project Analysis

**• Statistical / Regression Analysis
**

(forecasting)

• Sensitivity Analysis

• Monte Carlo Simulations

• Decision Trees

Decision Tree

What’s the

difference?

**Each shows a manager different aspects of the
**

decision he/she faces:

• Regression / Statistical Forecasting is a way to

estimate future sales growth based on current or

past performances.

• Sensitivity Analysis shows her how much each

variable affects the NPV.

• Monte Carlo gives a statistical breakdown of the

possible outcomes.

• Decision Trees are visual representations of the

average outcome.

Regression and

Statistical Forecasting

**• Mathematically model past sales of either same
**

product or similar product

• Projects future sales as a function of these past sales

with respect to time

**We will talk about two types of regression
**

• Linear Regression

• Polynomial Regression

(but there are many more, logarithmic, exponential, etc)

Quick primer on Statistics and Probability Definitions: Expected Value of x: E(x) = xP( x). root of the variance Median = “the center of the set of numbers”. as P(x) represents the probability of x. x (Note that P( x) = 1 and that the xP( x) E ( x) x because P(x) represents a probability density function) 2 Variance of x: E[( x X ) ] 2 X Standard Deviation = the sq. or the point m such that P(x < m)< ½ and P(x > m)> ½ . .

30 5 Year 6 $ 12. Simple Example – Widget Sales Annual Sale of Widgets Year 0 $ (12.30 Year 4 $ 14.44 -5 0 2 4 6 8 10 Year 9 $ (4.00 10 Year 5 $ 14.50 Series1 Year 7 $ 8.00) Year 1 $ (3.50) -10 Data Points -15 Time (in years) .30 15 Profits in $ Millions Year 3 $ 12.40) 20 Year 2 $ 4.43 0 Year 8 $ 3.

5 million – Year 2 = $5.0 million • What should he estimate his future sales to be? .) • Suppose Greg plans on releasing the next generation widget.1 million – Year 3 = $13. Widgets (cont. (old widget data on previous page) • He already has sales of: – Year 1 = $0.

Mmmm… more widgets Annual Sale of Widgets 14 Sales (in $ Millions) 12 10 8 Series1 6 4 2 0 0 2 4 6 8 Time (in years) .

Linear Projections Linear Projection 60 50 Sales (in $ M) 40 Actual Data 30 Projected Function 20 10 0 0 2 4 6 8 10 Time (in years) Propose that sales is: Assume f(x) = 6t .5. where t = number of years .

Regression – Least Squares • Is there a formal way to get this estimation function? • Fit a line such that the square of the vertical deviations between the function and the data points is minimized .

therefore function q = y – (B1 + B2x) q • Data point The square of q is = [ y – (B1 + B2)]2 The sum of all of the squares of q we will denote Q Q [y (B1 B2 x)] 2 .Derivation of Least Squares Regression Assume you have an arbitrary straight line: y = B1 + B2x [note. this is simply y = mx + b] Let q = the distance between the function point and the actual data point.

. y = Average y . so using partial derivatives and setting them = 0 we get Q Q 2 [y (B1 B2 x)] 2 [y (B1 B2 x)]x B1 B2 Setting these equations equal to zero and solving for B1 and B2 gives us. Derivation Continued… Recall.. n x y nxn yn Bˆ 2 i 1 i i Bˆ 1 yn Bˆ 2 xn n 2 2 i 1 x i nx n Which will yield the equation y = B1 + B2x ? x = Average x. we want to minimize Q.

previous data f(x). previous data x)” • This is a linear-fit regression command .A1:A3. no one really does this by hand any more… • Plot your data points in adjacent columns A B 1 0 0 2 1 0.B1:B3)" • Use “=forecast(x.1 4 3 13 5 4 "=forecast(A4. Using Microsoft Excel for Regression • Of course.5 3 2 5.

which eventually decline • Let’s try to find a function that takes the first set of widget sales into account. . it is unrealistic to have infinitely rising sales • Second.What’s wrong with this picture? • First. it doesn’t fit with Greg’s previous widget product’s sales.

8(x-4)2 + 13 . the function is f(x) = -. F(x) = ax2 + bx + c Projected Sales 14 12 New function 10 $ Millions 8 Series1 6 Data 4 2 data 0 -2 0 2 4 6 8 Time In fact.

. Least Squares Regression for Polynomials (You are not responsible for this material) • Minimize the sum Q of the squares of these differences: n Q [yi (B1 B2 x B3 x 2 . yielding the equation: f(x) = B1 + B2x + B3x2 + … + Bnx(n-1) .. Bk 1xik )]2 i 1 • This will yield a (k+1)x(k+1) matrix of equations that can be solved for Bi.

it can be used to forecast possible future trends. • In business. • You’re responsible for linear least squares regression only. Summary • Least squares regression is a common scientific & engineering practice. .

Sensitivity Analysis • Set up an Excel spreadsheet that will calculate your projects NPV • Individually change your assumptions to see how the NPV changes with respect to different variables • Helps to determine how much to spend on additional information .

From Principles of Corporate Finance.500 (wc) and $3.1 million (best case) customers • Market Share of between 4% (wc)and 16% (bc) after the first year • Unit price between $3. (c) 1996 Brealey/Myers .800 (bc) • Unit cost (variable) between $3.9 (worst case)– 1. Jalopy Motor’s Example Suppose that you forecast the following for an electric scooter project: • Market Size of .750 (bc) • Fixed costs between $40 (wc) and 20 million (bc).600 (wc) and $2.

000 34.000 $ 20.000.000 10 Year NPV $34.750 $ 3.013 57.000.000.000.500 $ 3.000.000 $ 30.000.000.000.337.000 .000.000 Revenue: $ 375.600 $ 3.013.000.000.000 Unit Cost (Variable) (150.800 Unit Cost (Variable) $ 3.000.000 Tax: $ 15.000.000) 34.000.000) 34.013 111.000.000) 34.000 Fixed Cost: $ 30.000.000 34.000 Net Cash Flow (net profit + Depcn) $ 30.Tax): $ 15.000.000 Variable Cost $ 300.000.000.337.013 50.000 1.100.000 $ 2.000 1.013 173.) Pessimistic Expected Optimistic Market Size 900.000.000 Net Profit (Pretax Profit .750 Fixed Costs $ 40.000 Discount Rate 10% Original Investment 150.337.000.000 Market Share 4% 10% 16% Unit Price $ 3.000 Market Share (104.000 Unit Price (42.000 Depreciation $ 15.337.013 65.000.17 Changing each variable individually yields the following NPV: Pessimistic Expected Optimistic Market Size 11.337.000 Fixed Costs 4.337. Jalopy Example (cont.

3 • Net Cash Flow is defined as net profit plus the tax savings you get from depreciation . – NPV = .150 + 30 [1 – (1. Explanations • NPV is calculated by subtracting the initial investment from the sum of yearly $30M net cash flow.1] = $34.1)10 / .

000.000 34.013 173.000.000.013 65.000 $ 20.000 Discount Rate 10% Original Investment 150.) Pessimistic Expected Optimistic Market Size 900.000.013 57.000.750 Fixed Costs $ 40.000 10 Year NPV $34.17 Changing each variable individually yields the following NPV: Pessimistic Expected Optimistic Market Size 11.000 Operating Cash Flow $ 30.013 50.500 $ 3.000.000.000 Market Share (104.000.000 $ 30.000 Depreciation $ 15.000) 34.600 $ 3.000 Net Profit: $ 15.000.013.000 .000 Revenue: $ 375.000) 34.100.750 $ 3.000 Unit Cost (Variable) (150.000.337.000 Fixed Cost: $ 30.000.337.000 Fixed Costs 4.000.000) 34.000 1.000.000.013 111.000.337.000.000.000 34.000 Tax: $ 15.000.000.000 $ 2.337.000.337.000 Unit Price (42.000. Jalopy Example (cont.000.000 Variable Cost $ 300.800 Unit Cost (Variable) $ 3.000 1.337.000 Market Share 4% 10% 16% Unit Price $ 3.

where are the chances) • Step 2 – Assign Probabilities to outcomes (assumption) • Step 3 – Simulate the Cash Flows (use a computer simulation program) • The result will be a probability distribution. Monte Carlo Simulations • Simulations are a tool for considering all possibilities • Step 1 – Model the project (where are choices made. .

Monte Carlo Simulation (cont.02 50 60 70 80 90 100 Test Scores .06 Probability Std. Dev = 20 0 -0.02 Std.1 0.08 0. Dev = 10 0.04 Std. Dev = 5 0.) (test scores example) Standard Distribution 0.

Equations (Mmmm… Math) • Normal Distribution: f(x | and ) ( x X )2 1 f ( x | X . ) 2 X e 2 X2 (2 )( X ) • Standard Normal Distributions have a mean (x) of 0 and a variance (2) of 1 .

Monte Carlo Simulations (projected cash flow) Cost of project Projected Cash Flows 0. Dev = 10 0. Dev = 5 0. .02 $0 $20 $40 $60 $80 NPV (in millions) The distribution shows the percentage of times the program predicts NVP above cost of project.02 Std.1 0.04 Std.08 0. Dev = 20 0 -0.06 Frequency Std.

•Dealing with continuous distribution. Summary Monte Carlo •You are not responsible for this on the test. •Statistical breakdown of possible outcomes. .

Probabilities. Decision Tree . • A Way of Breaking Down Complicated Situations Down to Easier-to-Understand Scenarios. and Opportunities. Consequences. What is a Decision Tree? • A Visual Representation of Choices.

Go to Graduate School to get my MBA. Easy Example • A Decision Tree with two choices. Go to Work “in the Real World” .

. • Lines connect outcomes to their choice or probability outcome. • A circle is used to show that a probability outcome will occur. Notation Used in Decision Trees • A box is used to show a choice that the manager has to make.

Easy Example . • Opportunity cost of salary • Anticipated future earnings .Revisited What are some of the costs we should take into account when deciding whether or not to go to business school? • Tuition and Fees • Rent / Food / etc.

000 = Go to Work “in the $425.000.000.000 . Simple Decision Tree Model 2 Years of tuition: $55.000 What is missing? Go to Business School .$175. minus expenses of $20. 2 years of Opportunity Cost of Salary = $100. NPV (business school) = $600.000 Real World” First two year salary = $100.000. 2 years of Room/Board: $20. Business School = $600.000 (from above).000 Is this a realistic model? NPV (no b-school) = $410. Final five year salary = $330.000.000. Go to Graduate School to get my PLUS Anticipated 5 year salary after MBA.000 Total = $175.

526 otherwise you have a Berkeley $54. it is only profitable Chicago $106.378 Stanford $97.749 .679 Texas $17.$3.459 Rochester .736 Business Schools – Yale Northwestern $83.775 $53.486 NEGATIVE NPV! UCLA $55.315 North Carolina .378 Yeaple.101 Wharton $59. 1994) Carnegie Mellon $18.$17.$307 Indiana .$4.502 Dartmouth $22.565 Duke .462 to go to one of the top 15 MIT (Sloan) $85.974 Michigan $21.$3. Aug.046 Cornell $30.088 Virginia $30.631 NYU .509 (Economist. The Yeaple Study (1994) Benefits of Learning According to Ronald School Net Value ($) Harvard $148. 6.

type of job / prestige. future salary. race) Human Factors Considerations . etc) • Cost of Living differences • Type of Job [utility function = f($. gender. Things he may have missed • Future uncertainty (interest rates. enjoyment)] • Girlfriend / Boyfriend / Family concerns • Others? Utility Function = f ($. location. enjoyment. family. age.

If she expands the factory. If she does nothing and the economy stays good and people continue to buy lots of gadgets she expects $3M in revenue.5M. The cost to expand her factory is $1. She is wondering whether or not it is a good idea to expand her factory this year. while only $1M if the economy is bad. She also assumes that there is a 40% chance of a good economy and a 60% chance of a bad economy. . Mary’s Factory Mary is a manager of a gadget factory. Her factory has been quite successful the past three years. (a) Draw a Decision Tree showing these choices. she expects to receive $6M if economy is good and $2M if economy is bad.

6 Bad Economy (60%) Profit = $1M NPVExpand = (.5 M .8.4(3) + .6(1) = $1.4 Profit = $3M Don’t Expand Factory Cost = $0 .8M $2.4(6) + .4 Profit = $6M Expand Factory Cost = $1. therefore you should expand the factory .6(2)) – 1.1 > 1.6 60% Chance Bad Economy Profit = $2M Good Economy (40%) .1M NPVNo Expand = .5 = $2. Decision Tree Example 40 % Chance of a Good Economy .

they anticipate making an additional $75.000 / year in salary and benefits. Example 2 – Joe’s Garage Joe’s garage is considering hiring another mechanic. If there are not a lot of accidents. The mechanic would cost them an additional $50.000 off of last year’s total net revenues. Draw a decision tree for Joe and tell him what he should do. Joe thinks that there will be a 70% chance of “a lot of accidents” and a 30% chance of “fewer accidents”. Because of all the ice on the roads. they could lose $20. .000 in net revenue. If there are a lot of accidents in Providence this year. Assume if he doesn’t expand he will have the same revenue as last year.

$20.000 • Therefore you should not hire the mechanic .$50.3 30% chance of a decrease Cost = $50.000 in accidents Profit = .000 = .000) + .$20.000) .$7.000 Don’t hire new mechanic Cost = $0 • Estimated value of “Hire Mechanic” = NPV =.000 .7 in accidents Hire new mechanic Profit = $70. Example 2 .Answer 70% chance of an increase .7(70.3(.

but will yield an additional $2M in profit when economy is good but only $1M when economy is bad. she can opt to either (a) expand the factory further if the economy is good which costs 1. Mary’s Factory – With Options A few days later she was told that if she expands. (b) abandon the project and sell the equipment she originally bought for $1.5M. and compute the NPV for the expansion. or (c) do nothing. (b) Draw a decision tree to show these three options for each possible outcome. .3M.

sell . with Options Expand further – yielding $8M (but costing $1. Decision Trees.3 in equipment cost) .3 .5) Bad Market Stay at new expanded levels – yielding $2M Reduce to old levels – yielding $1M (but saving $1.4 Good Market Stay at new expanded levels – yielding $6M Reduce to old levels – yielding $3M (but saving $1.6 equipment) Expand further – yielding $3M (but costing $1.5) .

5M = 6.3M = 4.3M = 2.5M – Do nothing = 2M – Abandon Project = 1M + 1. Present Value of the Options • Good Economy – Expand further = 8M – 1.5M – Do nothing = 6M – Abandon Project = 3M + 1.5M = 1.3M .3M • Bad Economy – Expand further = 3M – 1.

48 (new NPV) – 2.1 (old NPV) = $380. .3)] .1.5M = $2.000 You would pay up to this amount to exercise that option. NPV of the Project So the NPV of Expanding the factory is: NPVExpand = [.4(6.48M Therefore the value of the option is 2.5) + .6(2.

The gadget company uses a 10% discount rate. Should she expand the factory? . The cost of expanding the factory is borne in year zero but the revenue streams are in year one. she wants to account for the time value of money. (c) Compute the NPV in part (a) again. this time account the time value of money in your analysis. Mary’s Factory – Discounting Before Mary takes this to her boss.

4 Profit = $6M Expand Factory Cost = $1.5 M .6 60% Chance Bad Economy Profit = $2M Good Economy (40%) . Time Value of Money 40 % Chance of a Good Economy .4 Profit = $3M Don’t Expand Factory Cost = $0 .6 Bad Economy (60%) Profit = $1M Year 0 Year 1 .

091 .818.272 d) PV = 1(1.1)-1 = $1.1)-1 = $2.1)-1 = $5.454 b) PV = 2(1.1)-1 = $0. Time Value of Money • Recall that the formula for discounting money as a function of time is: PV = S (1+i)-n [where i = interest / discount rate.454.181 c) PV = 3(1. in each scenario.909. n = number of years / S = nominal value] • So.727. we get the Present Value (PV) of the estimated net revenues: a) PV = 6(1.

910) = 1.29 – 1.82M) = $3. .5M. the PV of the revenue streams (once you account for the time value of money) are: PVExpand =.6(.4(5.5M) + . should you expand the factory? Yes.79 > $1. Time Value of Money • Therefore.5 = $1.73) + 0.6(1.29M PVDon’t Ex. and that means the NPV = 3.4(2. you don’t discount it.64 • Note that since the cost of expansion is borne in year 0. because the cost of the expansion is $1.638 • So. = 0.

The next year she expects to earn $600.000. however it would take one year to renovate. implement her computer inventory system. She can buy it for $400. find the NPV of the project with a discount rate of 10% .000 if the economy is good and only $200. Taking the time value of money into account.000 if the economy is bad. Stephanie’s Hardware Store Stephanie has a hardware store and she is deciding whether or not to buy Adler’s Hardware store on Wickendon Street. etc. If she doesn’t buy Adler’s she knows she will get $0 additional profits. She estimates a 65% probability of a good economy and a 35% probability of a bad economy.

000 Buy Adler’s Cost = $400.000 Don’t Buy Additional Revenue = $0 Cost = $0 Year 0 Year 1 .000 35% Chance Bad Economy Profit = $200. Answer to Stephanie’s Problem 65 % Chance of a Good Economy Profit = $600.

65(600. Should she buy? • NPV of purchase = – . • What happens if the discount rate = 20%? – The NPV = .1) – 400.181.000/1.000 = $18.666. so it probably is not worth it.$16.67.82 • Therefore. so you should not buy! . she should do the project! • What happens if the discount rate = 15%? – The NPV = 0.000/1.35(200.1) + .

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