Risk and Probability

March 10, 2026

QOTD: Where is your favourite place in the world?

 • You are the owner of a business, preparing to develop your

BEFORE WE next big product. How much can you afford to spend on its
development?
BEGIN • It depends on how much revenue it will generate…
• But how do you know?

© Giuseppe Grande 2
IN TODAY’S LESSON…
• Risk in investing • Approximating • Probability distributions

ENG 3000: Engineering Economics © Giuseppe Grande 3

Risk in Investing
• So far, we’ve confidently assumed the costs, benefits, and interest rates in the future
• In reality, we likely don’t know exactly what will happen
• Costs could drop due to technology advancements
• Interest rates could rise sharply following world events
• People may not buy the product as much as you thought they would
• Turn and talk: how can we account for these things?

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Use a 3.5% interest rate to compare these alternatives in terms of NPW

A B

Cost $1000 $2000

Annual $150 $250

benefit
Useful life 10 years 10 years

Salvage $100 $400

value
Newnan et al (2018) Engineering Economic Analysis
Ex. 10-1, Pg. 295
Use a 3.5% interest rate to compare these alternatives in terms of NPW

A B

Cost $1000 $2000

Annual $150 $250

benefit
Useful life 10 years 10 years

Salvage $100 $300

value
Newnan et al (2018) Engineering Economic Analysis
Ex. 10-1, Pg. 295
Use a 3.5% interest rate to determine the break-even point for salvage value of alternative B

A B

Cost $1000 $2000

Annual $150 $250

benefit
Useful life 10 years 10 years

Salvage $100 ???

value
Newnan et al (2018) Engineering Economic Analysis
Ex. 10-2, Pg. 296
Risk in Investing
• The example illustrates that we can calculate with uncertainty in mind
• Could make a conservative estimate
• Could calculate the break-even point for some unknown value
• We may, instead, choose to replace individual values with ranges of predictions

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Uncertainty
• Say you’re a company releasing a big new product
• Projections predict you will make $3B in one year – lets call this the “likely” outcome
• Optimistically, maybe you could make $3.5B in one year
• Pessimistically, maybe you only make $1B in one year
• We could now calculate a range of values
• When planning product development, your company could prepare for the worst, most likely, or best case
• Of course, the “worst” and “best” cases are still predictions, but allow for some flexibility

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 A firm is considering an investment early in the project’s planning phase. They’ve developed a table of optimistic, pessimistic, and
likely outcomes based on their own historical data. Determine the rate of return for each option.
Optimistic Likely Pessimistic
Cost $950 $1000 $1150
Annual $210 $200 $170
benefit
Useful life 12 10 8
Salvage $100 0 0
value
Newnan et al (2018) Engineering Economic Analysis
Ex 10-3, Pg. 296
Approximating
• At the beginning of a project, there are many unknowns
• Anything other than initial costs/benefits is likely unknown
• Many of these factors will take the “likely” value, some will be higher, and others lower
• We will approximate the values of these factors using the following formula (a beta approximation)
• We’ll refer to this as “the beta approximation” or “the mean” of our estimates
𝑜𝑝𝑡𝑖𝑚𝑖𝑠𝑡𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 + 4 𝑚𝑜𝑠𝑡 𝑙𝑖𝑘𝑒𝑙𝑦 𝑣𝑎𝑙𝑢𝑒 + 𝑝𝑒𝑠𝑠𝑖𝑚𝑖𝑠𝑡𝑖𝑐 𝑣𝑎𝑙𝑢𝑒
𝑎𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑣𝑎𝑙𝑢𝑒 =
6

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 A firm is considering an investment early in the project’s planning phase. They’ve developed a table of optimistic, pessimistic, and
likely outcomes based on their own historical data. Approximate the rate of return
Optimistic Likely Pessimistic
Cost $950 $1000 $1150
Annual $210 $200 $170
benefit
Useful life 12 10 8
Salvage $100 0 0
value
Newnan et al (2018) Engineering Economic Analysis
Ex 10-4, Pg. 298
Order of operations
• Note that the rate of return calculated in the last example was 14.3%
• The beta approximation of optimistic, pessimistic, and likely ROR values from earlier would yield
(19.8 + 15.1 + 3.9)/6 = 14.0%

• When applying the beta approximation formula, find the mean values for each economic factors BEFORE applying the
economic analysis, as in the last example

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Brain Break
• Follow the provided instructions
Probability Distributions
• The probability of any outcome is a number ranging from 0 (impossible) to 1 (guaranteed)
• When rolling a standard, six-sided die:
1
• P(1) = 1/6 = 0.167 0.9
0.8
• P(even) = 3/6 = 0.5 0.7
0.6

• P(11) = 0 0.5
0.4
0.3
• A probability distribution is a continuous graph that shows these probabilities 0.2
0.1
0
1 2 3 4 5 6 7 8 9 10 11 12

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Probability Distributions
• In engineering economics, we won’t focus on continuous distributions
• While these would give more precise results, they are more complex than they’re worth
• It is simpler to predict and make calculations with a few discrete options
• 2-5 is common
• This is a trade-off between accuracy and complexity

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Probabilities of multiple events
• If two events are statistically independent, then the outcome of event A does not impact event B and vice versa
• In this case, P(A and B) = P(A) x P(B)
• Flip a coin and roll a six-sided die:
• P(H) = 0.5
• P(1) = 1/6
• P(1 and H) = 0.5 x 1/6 = 1/12
• What does the probability distribution look like for each event? What about the joint probability distribution?

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Probabilities of multiple events
• In economics, many of our costs and benefits can be considered independent
• For example, the uncertainty in annual benefits and useful life are normally independent
• You could argue if benefits are low, that affects useful life. We won’t go that deep here
• The probability distribution is based on the relationship from before
• P(A and B) = P(A) x P(B)

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A project has an initial cost of $25,000. There is a 60% probability that the annual benefits will be $8000, a 30% probability
that the annual benefits will be $5000, and a small chance it will be $10,000. A useful life of six years is twice as likely as a
useful life of nine years. Use an interest rate of 10% to calculate a probability distribution of the present worth.

Newnan et al (2018) Engineering Economic Analysis

Ex. 10-6, Pg. 301
IN TODAY’S LESSON…
• Risk in investing • Approximating • Probability distributions
• The future is uncertain • If you have a range of • Visual depictions of the
• Predicting costs and benefits optimistic, likely, and likelihood of an outcome
affects the outcome of pessimistic estimates, the
analyses approximate value is
somewhere in that range

Next Class: Expected values

ENG 3000: Engineering Economics © Giuseppe Grande 20
 Try it Yourself
• Determine the optimistic, most likely, pessimistic, and approximate net present value Optimistic = $16,067.03
of this project using a 9% interest rate. Likely = $7464.15
Optimistic Most likely Pessimistic Pessimistic = -$2940.58
Initial cost $5000 $7000 $10000 Approximate = $7128.79
Annual benefits $2500 $2200 $1800
Annual costs $200 $400 $700
Useful life 20 years 15 years 10 years
Salvage value $400 $200 $0
ENG 3000: Engineering Economics © Giuseppe Grande 21