Kuliah Ekonomi Teknik Kimia

JTK FT UGM 2012

Introduction
 Probability estimation assumed that all
values of costs, expenses, revenues,
economic lives, and acceptable rates of
return were known with certainty.
 Sensitivity analysis is used to determine
the effect of technical and economic
parameters on the profitability of a
project. The potential error of each
parametric variable is examined, as well
as its effect on the project.
Sensitivity analysis
 Break even analysis
 The Strauss Plot
 Relative profitability plot
 Tornado plot
Break even analysis
Break-even plot for
pricing alternatives.
A realistic break-even plot.
The Strauss Plot
Example: the Strauss plot
The
Strauss
plot
Relative probability plot
Tornado plot
Discussion of Sensitivity Analyses
 Only one variable at a time can be studied.
 Interrelated variables such as fixed capital
investment, maintenance, and other
investment items in operating expenses
and their effect upon one another cannot
be represented correctly.
 Synergistic effects particularly with respect
to marketing variables such as sale
volume, selling price, market share cannot
be taken onto account.
Uncertainty analysis
 To estimate the probability of a venture,
one needs to take some assumptions.
 Each assumption has its own degree of
uncertainty, and when taken together
these uncertainties can result in large
potential errors.
Estimates and Their Use in
Economic Analysis
Example 10-1.
Two alternatives are being considered. The best
estimates for the various consequences are as
follows:
A B
Cost $1000 $2000
Net annual benefit $150 $250
Useful life, in years 10 10
End-of-useful-life-salvage value $100 $400
If interest is 3.5%,which alternative has the better net
present worth (NPW)?
Example 10-1.
Alternative A
NPW = -1000+ 150(P/A, 3.5%,10) + 100(P/F, 3.5%,10)
= -1000 + 150(8.317) + 100(0.7089)
= -1000 + 1248+ 71
=+$319
Alternative B
NPW = -2000 + 250(P/A, 3.5%, 10) + 400(P/F, 3.5%,
10)
= -2000 + 250(8.317) + 400(0.7089)
= -2000 + 2079 + 284
= +$363
Alternative B, with its larger NPW, would be selected.
Example 10-2.
Suppose that at the end of 10years, the actual salvage
value for B were $300 instead of the $400 best
estimate. If all the other estimates were correct, is B
still the preferred alternative?

Revised B
NPW = -2000 + 250(P/A, 3.5%, 10) + 300(P/F, 3.5%,
10)
= -2000 + 250(8.317) + 300(0.7089)
= -2000 + 2079 + 213
=+$292  A is now the preferred alternative.
A Range of Estimates
 an optimistic estimate,
 the most likely estimate
 a pessimistic estimate
Example 10-3
A firm is considering an investment. The most likely
data values were found during the feasibility study.
Analyzing past data of similar projects shows that
optimistic values for the first cost and the annual
benefit are 5% better than most likely values.
Pessimistic values are 15% worse. The firm's most
experienced project analyst has estimated the
values for the useful life and salvage value.
Optimistic Most Likely Pessimistic

Cost $950 $1000 $1150

Net annual benefit $210 $200 $175
Useful life, in years 12 10 8
Salvage value $100 $0 $0
Example 10-3
 Compute the rate of return for each estimate. If a
10% before-tax minimum attractive rate of return is
required, is the investment justified under all three
estimates? If it is only justified under some
estimates, how can these results be used.
Example 10-3
Optimistic Estimate
PW of cost = PW of benefit
$950 = 21O(P/A, IRRopt,12) + 100(P/F,IRRopt, 12)
IRRopt = 19.8%

Most Likely Estimate

$1000 = 200(P / A, IRRmostlikely,10)
(P / A, IRRmostlikely,10) = 1000/200 = 5  IRRmostlikely =
15.1%

Pessimistic Estimate
$1150 - 170(P/A, IRRpess,8)
(P / A, IRRpess,8) = 1150/170 = 6.76  IRRpess= 3.9%
Example 10-3
 From the calculations we conclude that the rate of
return for this investment is most likely to be
15.1%, but might range from 3.9%to 19.8%.The
investment meets the 10%MARRcriterion for two
of the estimates. These estimates can be
considered to be scenarios of what may happen
with this project. Since one scenario indicates that
the project is not attractive, we need to have a
method of weighting the scenarios or considering
how likely each is.
Example 10-4
Compute the mean for each parameter:
Mean cost = [950 + 4 x 1000+ 1150]/6 = 1016.7
Mean net annual benefit = [210 + 4 x 200 + 170]/6 = 196.7
Mean useful life = [12 + 4 x 10+ 8]/6 = 10.0
Mean salvage life = 100/6 = 16.7

Compute the mean rate of return:

PW of cost = PW of benefit
$1016.7 = 196.7(P/A, IRRbeta,10) + 16.7(P/F,IRRbeta, 10)
IRRbeta= 14.2%
Probability
Example 10-5
What are the probability distributions for the annual
benefit and life for the following project? The
annual benefit's most likely value is $8000 with a
probability of 60%. There is a 30% probability that
it will be $5000, and the highest value that is likely
is $10,000. A life of 6 years is twice as likely as a
life of 9 years.
Example 10-5
Probabilities are given for only two of the possible
outcomes for the annual benefit. The third value is
found using the fact that the probabilities for the
three outcomes must sum to 1,
1 = P(Benefit is $5000) + P(Benefit is $8000) +
P(Benefit is $10,000)
P(Benefit is $10,000) = 1 - 0.6 - 0.3 = 0.1

The probability distribution can then be summarized

Annual benefit $5000
in a table. $8000 $10,000
Probability 0.3 0.6 0.1
Example 10-5
The problem statement tells us:
P(life is 6 years) = 2P(life is 9 years)
P(6) + P(9)= 1
Combining these, we write
2P(9) + P(9) = 1
P(9) = 1/3
P(6) = 2/3
The probability distribution for the life is P(6) = 66.7%
and P(9) = 33.3%.
Joint Probability Distributions
The project described in the previous example has a
first cost of $25,000. The firm uses an interest rate
of 10%. Assume that the probability distributions
for annual benefit and life are unrelated or
statistically independent. Calculate the probability
distribution for the PW.
Example 10-6
Since there are three outcomes for the annual benefit and
two outcomes for the life, there are six combinations.
The first four columns of the following table show the
six combinations of life and annual benefit. The
probabilities in columns 2 and 4 are multiplied to
calculate the joint probabilities in column 5. For
example, the probability of a low annual benefit and a
short life is 0.3 x 2/3, which equals 0.2 or 20%.

The PW values include the $25,000 first cost and the

results of each pair of annual benefit and life. For
example, the PW for the combination of high benefit
and long life is:
Example 10-6
Annual Joint
Probability Life Probability PW
Benefit Probability
$5,000 30% 6 66.70% 20.00% -3,224
8,000 60 6 66.7 40 9,842
10,000 10 6 66.7 6.7 18,553
5,000 30 9 33.3 10 3,795
8,000 60 9 33.3 20 21,072
10,000 10 9 33.3 3.3 32,590
100.00%
Probability distribution function for PW
Expected Value

The first cost of the project in Example 10-5 is $25,000.

Use the expected values for annual benefits and life to
estimate the present worth. Use an interest rate of 10%.
Example 10-7
EVbenefit = 5000(0.3) + 8000(0.6) + 10,000(0.1) =
$7300
EVlife = 6(2/3) + 9(1/3) = 7 years

The PW using these values is

PW(EV) = -25,000 + 7300(P/A, 10%,7) = -25,000
+6500(4.868) =$10,536

[Note: This is the present worth of the expected

values, PW(EV), not the expected value of the
present worth, EV(PW). It is an easy value to
calculate that approximates the EV(PW), which
will be computed using the joint probability
Example 10-8
Use the probability distributionfunction of thePWthat
was derivedin Example 10-6 to calculate the
EV(PW). Does this indicate an attractive project?

 The table from Example 10-6 can be reused with

one additional column for the weighted values of
the PW (= PW x probability). Then, the expected
value of the PW is calculated by summing the
column of present worth values that have been
weighted by their probabilities.
Example 10-8
PW x
Joint
Annual Probabilit Probabilit Joint
Life Probabilit PW
Benefit y y Probabili
y
ty
$5,000 30% 6 66.70% 20.00% -3,224 -$ 645
8,000 60 6 66.7 40 9,842 3,937
10,000 10 6 66.7 6.7 18,553 1,237
5,000 30 9 33.3 10 3,795 380
8,000 60 9 33.3 20 21,072 4,214
10,000 10 9 33.3 3.3 32,590 1,086
100.00% EV(PW) = $ 10,209
Example 10-8
With an expected PW of $10,209, this is an attractive
project. While there is a 20% chance of a negative PW,
the possible positive outcomes are larger and more
likely. Having analyzed the project under uncertainty,
we are much more knowledgeable about the potential
result of the decision to proceed.
The 10,209 value is more accurate than the approximate
value calculated in Example10-7. The values differ
because PW is a nonlinear function of the life. The
more accurate value of $10,209 is lower because the
annual benefit values for the longer life are discounted
by 1/(1 + i) for more year.
Example 10-9
A dam is being considered to reduce river flooding.
But if a dam is built, what height should it be?
Increasing the dam's height will (1) reduce a
flood's probability, (2) reduce the damage when
floods occur, and (3) cost more. Which dam height
minimizes the expected total annual cost? The
state uses an interest rate of 5% for flood
protection projects, and all the dams should last
50 years.
Example 10-9
Dam Annual Damages If
First Cost
Height (ft) P (flood) x Height Flood Occurs
No dam $0 0.25 $800,000
20 700,000 0.05 500,000
30 800,000 0.01 300,000
40 900,000 0.002 200,000
Example 10-9
 The easiest way to solve this problem is to choose
the dam height with the lowest equivalent uniform
annual cost (EUAC). Calculating the EUAC of the
first cost requires multiplying the first cost by (A/P,
5%, 50). For example, for the dam 20ft high this is
700,000(A/P,5%, 50)= $38,344.
 Then the EUAC of the first cost and the expected
annual flood damage are added together to find
the total EUAC for each height. The 30 ft dam is
somewhat cheaper than the 40 ft dam.
Example 10-9
Expected
EUAC of first Total Expected
Dam height (ft) annual flood
cost EUAC
damages
No dam $0 $200,000 $200,000
20 38,344 25,000 63,344
30 43,821 3000 46,821
40 49,299 400 49,699
Risk
 Risk can be thought of as the chance of getting an
outcome other than the expected value with an
emphasis on something negative.
 One common measure of risk is the probability of
a loss (see Example 10-6).
 The other common measureis the standard
deviation (a), which measures the dispersion of
outcomes about the expected value
Example 10-13
 Using the probability distribution for the
PW from Example 10-6, calculate the
PW's standard deviation.
Example 10-13
Joint PW x PW2 x
Annual Probab Probabilit
Life Probabil PW Probabili Probability
Benefit ility y
ity ty
$5,000 30% 6 66.70% 20.00% -3,224 -$ 645 $ 2,079,480
8,000 60 6 66.7 40 9,842 3,937 38,747,954
10,000 10 6 66.7 6.7 18,553 1,237 22,950,061
5,000 30 9 33.3 10 3,795 380 1,442,100
8,000 60 9 33.3 20 21,072 4,214 88,797,408
10,000 10 9 33.3 3.3 32,590 1,086 35,392,740
100.00% 10,209 189,409,745
Risk Versus Return
 Example 10-14
 A large firm is discontinuing an older product, so some
facilities are becoming available for other uses. The
following table summarizes eight new projects that
would use the facilities. Considering expected return
and risk, which projects are good candidates? The firm
believes it can earn 4% on a risk-free investmenting
government securities (labeed as project F).
Example 10-14
Project IRR Standard Deviation
1 13.10% 6.50%
2 12 3.9
3 7.5 1.5
4 6.5 3.5
5 9.4 8
6 16.3 10
7 15.1 7
8 15.3 9.4
F 4 0
Example 10-14
 Answering the question is far easier if
we use Figure 10-7.Since a larger
expected return is better, we want to
select projects that are as "high up" as
possible. Since a lower risk is better, we
want to select project that are as "far
left" as possible. The graph lets us
examine the trade-off of accepting more
risk for a higher return.
Example 10-14

efficient frontier.

dominated projects.
Simulation
 Example 10-15
 ShipM4U is considering installing a new, more
accurate scale, which will reduce the error in
computing postage charges and save $250 a year.
The scale's useful life is believed to be uniformly
distributed over 12, 13, 14, 15,and 16 years. The
initial cost of the scale is estimated to be normally
distributed with a mean of $1500 and a standard
deviation of $150.
 Use Excel to simulate 25 random samples of the
problem and compute the rate of return for each
sample. Construct a graph of rate of return versus
frequency of occurrence
Example 10-15
250 Annual savings
Life First Cost
Min 12 1500 Mean
Max 16 150 Std dev

Iteration IRR
1 15 1510 14%
2 13 1217 18%
3 12 1391 14%
4 14 1297 17%
5 13 1621 12%
…
25 14 1408 15%
Example 10-15
IRR vs Frequency
5

3
Frequency

0
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19%
IRR
Example 10-16
 Consider the scale described in
Example 10-15. Generate 10,000
iterations and construct a frequency
distribution for the scale's rate of return.
10-16