1. ENGINEERING ECONOMICS ISE460 SESSION 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

2. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 2 Quiz Results

3. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 3 Quiz Results

4. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 4 Quiz Results

5. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 5 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

6. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 6 Recommendations Science Museum (we spent 6 hours) –Near V&A in Kensington –Fabulous »Computing, Mathematics, Space Tate Modern (we spent 3 hours) –Development of 20 th century art

7. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 7 Recommendations From The Science Museum –An artifact I was remotely involved in and also led to meeting Barbara

8. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 8 Risk Sensitivity Analysis Break Even Analysis Simulation

9. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 9 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

10. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 10 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

11. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 11 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

12. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 12 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

13. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 13 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)

14. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 14 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

15. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 15 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)

16. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 16 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)

17. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 17 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

18. ENGINEERING ECONOMICS ISE460 SESSION 21 CHAPTER 12, July 2, 2014 Geza P. Bottlik Page 18 SIMULATION