Engineering Economics
Lecture – Six
Alternatives Risk Analysis
1
Introduction:
In all our previous discussions we had arrived at a
particular decision (in the form of acceptance or
rejection of a proposal, and the selection of one
alternative among different possible alternatives) in a
given situation assuming that the estimates or the
expected value for different variables such as:
Initial cost,
Incomings,
Disbursements,
Interest rate,
Life of the assets,
Salvage value etc … were accurate and constant.
Cont...
Unfortunately in real life situation it is not the case.
Excepting few variable, such as initial cost of the asset,
rest all the variables our estimates or forecasts which
may prove to be wrong on most of the occasions.
The life of the asset could be longer or shorter than
our estimate; the interest rate could be higher or
lower than the assumed value and so on.
Change will happen to the net present worth
associated with a particular investment alternative
when some variables like incomings (receipts) value
or outgoings (disbursement) value vary from its
expected value.
1. Sensitivity Analysis:
Sensitivity analysis thus is aimed to study the impact of
change in the value of variable(s) on the economic
decision in a particular situation.
In a sense it aims to answer “what if”.
For example what will happen if the annual disbursement value
increases by 10% or 20% from the current value? Will it turn the
positive present worth into negative? Will it change the earlier
decision?
The changes (increase or decrease in the assumed values)
in the variable values may or may not lead to reversal of
our earlier decision.
If even a slight change in one variable makes the reversal
of decision from let’s say acceptance of one alternative to
the rejection we say that the variable is highly sensitive.
Cont...
Whereas, even if a large change in one variable does not change
the decision we say that the variable is not sensitive or
insensitive.
The sensitivity analysis is used to identify the sensitivity of a
particular variable.
Once the identification has been made of variables in categories
such as:
Highly sensitive,
Less sensitive or insensitive
The management can focus their attention to the highly sensitive
variables.
That is for such variables they can put more energy and effort in
preparing their estimate.
In some situations, external help in the form of engagement of
consultants can also be thought of.
Cont...
Sensitivity analysis is basically a non-probabilistic technique.
There could be different forms of sensitivity analysis. These
are depicted in Fig.
Sensitivity analysis
More than one
Single alternative
alternative
Change in one variable Spider web diagram Change in one variable
at a time at a time
Family of curves or Change in two variables
Change in two variables Isoquants
at a time
at a time
Scenario analysis
Change in more than Change in more than
two variables at a time two variables at a time
Cont...
Sensitivity analysis can be performed with any method
of evaluation of alternatives for example, present worth
analysis, annual cost analysis or internal rate of return
method of analysis.
Also the analysis can be performed at different stages of
project either with the pre tax cash flow or post tax
cash flows.
However, it is preferable to perform sensitivity analysis
with post tax cash flow. It is usual to show the results
of sensitivity analysis in the form of sensitivity graphs.
Illustration…. One alternative
Consider the given Description Alternative 1
alternative to acquire a
new piece of Acquisition Birr. 500,000
equipment. The cost
acquisition cost, Incomings Birr. 100,000
incomings, outgoings, every year for
salvage value, interest 10 years
rate and service life Outgoings Birr. 5,000 every
associated with the year for 10
alternative are provided years
in the following table.
Salvage value Birr. 50,000
Interest rate 12%
Service life 10 years
Cont...
NPW = -500,000 + 100,000(P/A, 12%, 10) – 5,000(P/A, 12%, 10) +
50,000(P/F, 12%, 10) = 48100
Let’s assume that the estimate of incoming value goes wrong and
instead of Birr. 100,000 it is Birr. 90,000. Thus the new net present
worth keeping all other variables same would be -7900 (-500,000 +
90,000(P/A, 12%, 10) – 5,000(P/A, 12%, 10) + 50,000(P/F, 12%, 10).
We find that the decision taken on net present worth would get
reversed.
The above analysis could be performed in terms of percentage
variation in incoming values also.
Let the percentage variation in incomings be x. We can find the
percent change in incomings at which the net present worth
becomes zero.
-500,000 + 100,000*5.6*x – 5,000*5.6 + 50,000*0.322 = 0
X= 91.4, therefore 100-91.41= 8.59% income decreased, NPV become
zero
Cont...
The value of incoming at which net present worth is zero is
known as break even point.
The sensitivity graphs showing the effect of changes in
incomings on net present worth both in terms of absolute
values and in terms of percentage are shown in Fig.
Fig. Sensitivity graph showing the effect of changes in
incomings on net present worth
Cont...
Similar analysis can be performed by changing other variables
one at a time and take the variables: incomings and service
life together then study their sensitivity and draw combined
sensitivity graph. ………..(Home work).
The slope of the sensitivity line indicates the sensitivity of a
particular variable.
The steeper the slope, the more sensitive the variable is and
the milder the slope, the less sensitive the variable.
There are two ways in which we can show the results of the
sensitivity analysis. These are
I. Family of curves and
II. Isoquants.
Cont...
1. Family of curves representation
One variable is kept fixed while another variable is
varied. For example,
let’s assume that service life N is fixed at some value N1
and net present worth is computed for different values of
incomings R. This process is repeated for N= N2 (say).
2. Isoquants
An indifference line is plotted by varying two variables say
service life N and incomings R at a time while keeping all the
other variables fixed. For drawing the indifference line first
we try to get points say (N1,R1), (N2,R2),…at which net
present worth is zero.
Illustration…. More than one alternative
The sensitivity
analysis
corresponding to
changes in one
variable, we take
up the following
two alternatives
in which the
information on
acquisition cost,
the incomings, the
outgoings, salvage
values, interest
rate, and service
life are provided.
Cont...
The net present worth of alternative 1 =48100
The net present worth of alternative 2 =4880
Now let’s change each of these variables one by one. For
example, consider the changes in the variable ‘incoming’.
In case the ‘incoming’ of alternative 1 changes to 90,000
from the existing 100,000 the new net present worth of
alternative 1 changes to -7900.
Such analysis addresses the questions such as:
At what value of incomings the alternative 1 is preferred to
alternative 2?
At what service life of the assets, the alternative 1 is
preferred to alternative 2?
Cont...
limitation of sensitivity analysis:
It is non probabilistic in nature.
Commonly, in sensitivity analysis only one variable is changed
at a time which may not reflect the real world situation as
variables tend to move together
There is subjectivity(bias) involved in the sensitivity analysis.
Thus the sensitivity analysis may lead one decision maker to
accept the proposal while other may reject it.
Benefits of performing sensitivity analysis:
It shows how a particular alternative is to changes in the value
of different variables
It enables the decision maker to distinguish the sensitive
variables from insensitive variables thus the decision maker
can focus its attention in making the estimate of sensitive
variables
2. Scenario Analysis:
Conducting scenario analysis is the best approach when
performing sensitivity analysis involving changes in more than
two variables at a time.
In scenario analysis a number of scenarios such as best
scenario, normal scenario, and worst scenario (in some texts
these scenarios are referred to as: less favorable estimate,
objective estimate, and more favorable estimate) are
generated.
The objective of such scenario analysis is to get a feel of
what happens under the most favorable or the most adverse
configuration of key variables.
Cont...
For example the best, normal and the worst scenario for the
previous example could be as given below:
Cont...
Corresponding to each of the above scenarios, the net
present worth can be computed.
Based on the net present worth values for each of the
scenarios the decision maker would be in a better
position to take the decision.
For example, if the net present worth corresponding to
worst scenario is a large negative value, and the net
present worth corresponding to the normal and best
scenarios are low positive value, and moderate positive
value the decision would be not to acquire the asset.
Cont...
Advantages of Scenario Analysis:
Scenario analysis is considered superior to
sensitivity analysis because it considers variations in
more than two key variables together.
Limitations of Scenario Analysis:
It assumes that there are few well delineated
scenarios which may not be true in many cases.
There is a huge requirement of data to perform
scenario analysis.
For example even for 6 input variables we would require
6 x 3=18 input data altogether corresponding to the best,
normal and worst scenarios.
3. Break even analysis:
Another way for assessing project risk
Here we are more concerned about finding the value (called
the break even point) at which the reversal of decision takes
place.
In the sensitivity analysis not much emphasis was given on
finding this break even value.
In sensitivity analysis we ask what will happen to the project if
the invoice or billing declines or costs increase or something
else happens.
We will also be interested in knowing how much should be
produced and sold at a minimum to ensure that the project
does not 'lose money'.
Such an exercise is called break-even analysis and the minimum
quantity at which loss avoided is called the break-even point.
Cont...
The break even analysis is also referred to as cost-
volume-profit analysis.
Addresses the decision of whether to make or buy
a product. whether to own or rent an equipment
Making the product involves two cost elements:
Fixed costs such as machine renting cost and
operation expenses
Variable costs such as raw material cost
Buying the product involves only one cost element,
the selling price. However, the price may either be
constant or variable based on the quantity
Cont...
Definitions:
Fixed/Variable Costs - If costs change appreciably with fluctuations in
business activity, they are “variable.” Otherwise, they are “fixed.” A widely
used cost model is: Total Costs = Fixed Costs + Variable Costs
Price - is the amount of money, goods or services that must be given up
to acquire ownership or use of a product
Direct/Indirect Costs - If costs can be reasonably measured and allocated
to a specific output, they are “direct.” Otherwise they are “indirect.”
Overhead Costs - All costs of providing goods or services other than
direct labor and direct material. Indirect costs are a subset of overhead
costs. Allocation of overhead to specific outputs may be in proportion to:
1. Direct labor hours
2. Direct material costs
3. Machine hours
E.g.. Overhead costs are:- Heat and light, property taxes, depreciation
Opportunity Costs - The cost of forgoing the chance to earn interest (
profit) on investment funds.
Illustration
A ready mix concrete (RMC) manufacturer wants to find
out the minimum production of concrete which will just be
able to recover its total cost incurred in a particular month.
The total cost (TC) incurred in a month is the sum of total
indirect cost (IC) and direct cost (DC).
The indirect costs in this example are those costs which are
incurred irrespective of concrete production taking place or
not.
However, the direct costs are proportional to the volume or
quantity of production.
By definition the total cost TC = IC + DC
Cont...
Let the sales price fixed by the RMC supplier is P per unit
concrete sold.
If the quantity of concrete sold is n units, the revenue R
would be computed by the expression R= n x P.
The total cost TC = IC + n x DC
Gross profit Z for the period would be defined as:
Z = R – TC = n x P – IC – n x DC
= n x (P-DC) – IC.
The net profit after taking taxes into account is given by Z’=
Z x (1-t) where t is the tax rate.
Break even point is defined where profit equals zero. In
order to determine the concrete quantity n at which the
RMC seller just recovers its total cost, we equate total cost
to revenue.
Cont...
Thus at break even point, Total cost TC = Revenue R. (Note
at this point Profit Z = 0).
We have,
TC = R at break even.
n x DC + IC = n x P
B x DC + IC = B x P (the quantity produced at break
even point is denoted with B, thus n= B at break even.)
B = IC/ (P-DC)
The denominator (P-DC) in the expression is also known as
‘contribution’.
For n less than B, the RMC seller is making losses, while for
n greater than B, the RMC seller is making profits.
The result of break even analysis is shown on the break even
chart.
Example:
A Ready Mix Concrete company sells RMC for a price of
birr. 3500/ cum. If the fixed cost of the company for the
production are bir. 40,000/month and the variable cost
associated with per cum production of RMC is birr. 1500/
cum, determine the breakeven quantity
Thank you
The END