Chapter 18

Sensitivity
Analysis and
Staged
Engineering Economy, 8th edition Decisions
Leland Blank, Anthony Tarquin

 ©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Homework

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Solution

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Homework

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16.24 Select any first cost value to use for B. The
spreadsheet below uses $10,000.
DDB: d = 2/5 = 0.40 125% DB: d = 1.25/5 = 0.25
DDB accumulates percentage faster and more in
total than 125% DB.

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Homework

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Solution

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Homework

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 Solution
16.40 Percentage depletion for gold is 15% of
gross income, provided it does not exceed 50% of
taxable income.

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 LEARNING OBJECTIVES

1. Explain sensitivity to parameter variation

2. Use three estimates for sensitivity analysis
3. Calculate expected value E(X)
4. Determine E(X) of cash flow series
5. Use decision trees for staged decisions
6. Understand real options for staged funding

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18-2
 Parameters and Sensitivity Analysis
Parameter -- A variable or factor for which an estimated or
stated value is necessary
Sensitivity analysis – An analysis to determine how a
measure of worth (e.g., PW, AW, ROR, B/C) changes when
one or more parameters vary over a selected range of values.

PROCEDURE:
1.Select parameter to analyze. Assume
independence with other parameters
2.Select probable range and increment
3.Select measure of worth
4. Calculate measure of worth values
5. Interpret results. Graph measure vs.
parameter for better understanding
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18-3
 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.

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 Solution by Hand
(a) Let i = 10%, 15%, 20%, 25%
PW = - 80,000 + 25,000(P/A,i,10) -
2000(P/G,i,10)

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 Solution by Hand
(b) Let n = 8, 10, 12
PW = - 80,000 + 25,000(P/A,15%,n)
- 2000(P/G,15%,n)

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Solution by Hand

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Solution by Spreadsheet

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 Sensitivity of Several Parameters
When several parameters for one alternative vary
and analysis of each parameter is required …
graph percentage change from the most likely estimate
for each parameter vs. measure of worth

Plots with larger

slopes (positive or
negative) have a
higher sensitivity with
parameter variation
(sales price curve)

Plots that are

relatively flat have
little sensitivity to
parameter variation
(indirect cost curve)
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18-4
 Three Estimate Sensitivity Analysis
 Applied when selecting one ME alternative from two or
more
 For each parameter that warrants analysis, provide
three estimates:
 Pessimistic estimate P
 Most likely estimate ML
 Optimistic estimate O
 Calculate measure of worth for each alternative and 3 estimates
and select ‘best’ alternative
Notes -- 1. The pessimistic estimate may be the lowest for some parameters and
the highest for others, e.g., low life estimates and high first cost
estimates are usually pessimistic
2. When calculating the measure of worth, use ML estimate of a
parameter as others varies. This is the independence assumption
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18-5
 Example
An engineer is evaluating three alternatives for
new equipment at Emerson Electronics. She has
made three estimates for the salvage value,
annual operating cost, and life. The estimates
are presented on an alternative-by-alternative
basis in Table 18–1. For example, alternative B
has pessimistic estimates of S = $500, AOC =
$4000, and n = 2 years. The first costs are
known, so they have the same value. Perform a
sensitivity analysis and determine the most
economical alternative, using AW analysis at a
MARR of 12% per year.
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Solution

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B is the most economical alternative.

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 Expected Value Calculations
Expected Value -- Long-run average observable if a project
or activity is repeated many times

Result is a point estimate based on anticipated outcomes

and estimated probabilities
m
E ( X )   X i P( X i )
i 1

Where: Xi = value of variable X for i = 1, …, m different values

P(Xi) = probability that a specific value of X will occur

In all probability statements, the sum is: When E(X) < 0, e.g., E(PW) = $-2550, a
m

 P( X )  1.0
i 1
i
cash outflow is expected; the project is
not expected to return the MARR used
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18-6
 Example: Probability and Expected Value
Monthly M&O cost records over a 4-year period are shown in
$200 ranges. Determine the expected monthly cost for next
year,
if conditions remain constant.
Range,$, X No. of months Range,$, X No. of months
100 - 300 4 700 - 900 6
300 - 500 12 900 - 1100 10
500 - 700 14 1100 - 1300 2

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18-7
 Example: Probability and Expected Value
Monthly M&O cost records over a 4-year period are shown in
$200 ranges. Determine the expected monthly cost for next
year,
if conditions remain constant.
Range,$, X No. of months Range,$, X No. of months
100 - 300 4 700 - 900 6
300 - 500 12 900 - 1100 10
500 - 700 14 1100 - 1300 2

Solution: P(X) = number of months / 48 months

E(X) = 200(4/48) + 400(12/48) + ··· + 1200(2/48)
= 1/48[200 × 4 + 400 × 12 + ··· + 1200 × 2]
= 1/48[31,200 ]
= $650 / month 18-7 © 2012 by McGraw-Hill All Rights Reserved
 Expected Value for Alternative Evaluation

Two applications for Expected Value for estimates:

1. Prepare information for use in an economic analysis
2. Evaluate economic viability of fully formulated alternative

Example: Second use for a complete alternative. Is the investment viable?

P = $-5000
n = 3 years
MARR = 15%

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18-8
 Example: Expected Value for Alternative
Evaluation

Solution: Calculate PW value for each condition

PWR = -5000 + 2500(P/F,15%,1) + 2000(P/F,15%,2) +

1000(P/F,15%,3)
= $-656 (cash outflow; not viable)
PWS = $+708 (cash inflow; viable)
PWE = $+1309 (cash inflow; viable)
Now, calculate expected value of PW estimates
E(PW) = PWR × P(R) + PWS × P(S) + PWE × P(E)
= -656 × 0.4 + 708 × 0.4 + 1309 × 0.2
= $+283
On basis of E(PW) > 0 at 15%
18-9over 3 years, investment is viable
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Class 2

29
 Decision Tree Characteristics
Staged Decision – Alternative has multiple stages; decision at one
stage is important to next stage; risk is an inherent element of the
evaluation
Decision Tree – Helps make risk more explicit for staged decisions

A DECISION TREE INCLUDES:

► More than one stage of selection
► Selection of an alternative at one stage
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
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18-10
 Solving a Decision Tree
Once the tree is developed, probabilities and economic information
are estimated for each outcome branch, and the measure of worth
is
selected (usually PW), use the following, starting at top right of tree:
PROCEDURE TO SOLVE A DECISION TREE
1. Determine PW for each outcome branch
2. Calculate expected value for each alternative:
E(decision) = ∑ (outcome estimate) × P(outcome)
3. At each decision node, select the best E(decision) value
4. Continue moving to left to the tree’s root to select the best
alternative
5. Trace the best decision path through the tree
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18-11
 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 flow before taxes) are
indicated. These payoffs are in millions
of dollars. Determine the best decision at
the decision node D1.
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 Example: Solving a Decision Tree
1. PW of CFBT is estimated
14 2. PW for decision nodes
E(int’l) = 12(0.5)+16(0.5) = 14
D2
E(nat’l) = 4(0.4)-3(0.4)-1(0.2) = 0.2
D2

E(int’l) = 6(0.8)-3(0.2) = 4.2

D3
4.2 E(nat’l) = 6(0.4)-2(0.4)+2(0.2) = 2

3. Decisions: 14 (int’l) and (int’l)

D3
4. PW for decision node D1
D1 E(market) = 14(0.2)+4.2(0.8) =
D1
6.16
E(sell) = 9(1.0) = 9
Decision: 9 (sell)
5. Trace through tree; select D1 to
sell at E(PW of CFBT ) = $9 million
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18-12
 Real Options
Staged funding ─ Decision to buy or invest can be delayed. There
is usually cost and risk involved to delay the decision

Option ─ Contractual Real option ─ In engineering

agreement to take a specified economy, the option can involve
action at some stated future physical assets (thus the title real
time. In other words, pay some option), leases, subcontracts,
amount now to reserve the etc. Risk analysis is always
right to accept or reject an offer involved for the predictable
in the future future events
Realoption
Real optionexample:
example:AnAnairline
airlinepurchases
purchases33commercial
commercialplanes
planesnownowand
andpays
pays
$2million
$2 millionto
tothe
themanufacturer
manufacturerfor forthe
theoption
optiontotobuy
buyup
uptoto55more
morewithin
withinthe
the
next33years
next yearsat
attoday’s
today’sprice.
price.
IfIfaccepted,
accepted,the
the$2
$2million
millionisis25%
25%credited
creditedtoward
towardthe
thedelayed
delayedpurchase;
purchase;ififthe
the
optionisisnot
option notexercised
exercisedwithin
within33years,
years,the
theentire
entire$2
$2million
millionisisforfeited.
forfeited.
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18-13
 Real Options Analysis

Real options analysis ─ Determine the economic consequences

of delaying the funding decision, that is, analyze staged funding

PRIMARY CHARACTERISTICS OF REAL OPTIONS ANALYSIS

 Cost of option to delay, i.e., PW of investment/payment required now

 Future options and cash flow estimates (staged funding)
 Time period for follow-on decision (staged decision)
 Market and risk-free interest rates (MARR and estimated inflation)
 Estimates of risk, i.e., probabilities for each option’s cash flows
 Economic criterion (PW, ROR) to make a decision now on the real option
 If needed, decision tree of options, probabilities, and cash flow estimates
to assist with the analysis
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18-14
 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. 37
(a) Develop the two-stage decision tree for the options described.
(b) The base case is the 1 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.
(c) Determine the PW values for each possible final outcome at
10% per year, and identify the best economic option when the 38
stage 2 funding decision must be made.
Solution

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 Solution
(b)

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(c)

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 Example: Real Options Analysis
A real estate developer has the option to buy prime property 2 years from now for $35M,
if a $3.5M option is purchased now. In 2 years, the economy can be ‘up’ or ‘down’ and the
decisions then are: (1) exercise the option (buy at $35M) and hold; (2) exercise and sell
immediately; or (3) forfeit. PW of eventual net cash flows for further development are
predicted in year 2 depending upon the economy (up or down). Selling price (high or low)
2 years hence is estimated. At MARR = 12%, what is better economically now ; to accept or
to decline the option? Assume probabilities and cash flows are estimated as follows:

PW of CF, Estimated
year 2, Selling P(selling selling price,
Economy P(economy) if held, $M environment environment) $M
High 0.4 50
Up 0.3 50
Low 0.6 40
High 0.4 30
Down 0.7 30
Low 0.6 25

Solution: Construct the 2-stage decision tree for time now and 2 years from
now. Probabilities and PW of cash flows are shown on the tree.
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18-15
 Example: Real Options Analysis
YEAR NOW 2 Future outcome
Exercise/hold -35 + 50 = $15M
15M
High
Exercise
(-35 +50)(0.4) = $6M
D2 P = 0.4
/sell

Accept Low (-35+40)(0.6) = $3M

UP
option P = 0.6
P = 0.3
0.1M -$3.5M Forfeit $0
D1
DOWN Exercise/hold -35 + 30 = $-5M
Decline P = 0.7 0 High
(-35+30)(0.4) = $-2M
option Exercise P = 0.4
0$ D3 /sell

Low (-35+25)(0.6) = $-6M

P = 0.6

Forfeit $0
0 Largest E(X)
of decision
$0 branches
P = 1.0
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18-16
 Example: Real Options Analysis
D2 analysis: PW in year 2, PW2
Tree from previous slide Exercise/hold: PW2 = purchase + PW of future
cash flows = -35 + 50 = $15M
Exercise/sell; high: PW2 = (-35+50)(0.4) = $6M
Exercise/sell; low: PW2 = (-35+40)(0.6) = $3M
Forfeit: 0
D2 decision: Select exercise/hold at $15M

D3 analysis: PW in year 2, PW2

D3 decision: Select forfeit at 0

D1 analysis: PW in year 0 (NOW), PW0

Accept option; up: PW0 = option $ + PW of D2
= -3.5 + 15(P/F,12%,2)(0.3) = $0.1M
Accept option; down: PW0 = -3.5+0(0.7) = $-3.5M
Decline option: PW0 = 0
CONCLUSION: Accept option now;D1
buydecision:
propertySelect
in twoaccept option
years and holdat
it $0.1M
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18-17
 Summary of Important Points
Sensitivity analysis evaluates variation in parameters using a
specific measure of worth (PW, ROR, B/C, etc.)

Independence of parameters is assumed in sensitivity analysis

If E(PW) < 0, an alternative is not expected to return the stated

MARR, given the estimated probabilities

Decision trees assist in making staged decisions when risk is

explicitly considered

Real options analysis determines the economic consequences of

delayed funding with risk accounted for; however, an up-front
price is usually imposed to have the option of staged funding

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18-18
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