COURSE TITLE

ENGINEERING ECONOMIC
ANALYSIS
Chapter 6 - (Week 11)
RISK ANALYSIS

LECTURE – 11
Sensitivity Analysis, Decision Tree Analysis, Scenario Analysis,
Risk Adjusted MARR

Er. Ishwar Adhikari

Associate Professor
Kathmandu Engineering College, Nepal
 Learning Objective
After studying this lecture students will be able to learn:

⮚Concept of Sensitivity Analysis with example

⮚Concept of Decision Tree Analysis with example

⮚Concept of Scenario Analysis and Risk adjusted MARR

 SENSITIVITY ANALYSIS

What are the Parameters

(variables) Used in
Engineering Economic
Analysis????
SENSITIVITY ANALYSIS (Cont’d….)

They are :
1. Initial Cost (I)
2. Annual Operating Cost (AOC)
3. Salvage Value (S)
4. Useful life (N)
5. Interest rate (i)
6. Inflation rate (f)
7. Annual Revenues (A)
 SENSITIVITY ANALYSIS (Cont’d….)

⮚In economic analysis, all the estimate made of these

parameters are ‘best estimates’ made by experienced
personnel i.e. the same value will occur during the
implementation phase of the project.
⮚But in the real practice, the budgeting or estimate of these
variables are uncertain i.e. there are variables which may not
occur as expected.
⮚Sensitivity analysis tries to seek the solution what the
outcome of the project will be if one of these variables
changes from the best estimates.
 SENSITIVITY ANALYSIS (Cont’d….)
Sensitivity analysis tries to answer the question of

‘ If the economic variables changes from expectation, what will the

effect be on business, model system, or whatever being analyzed, and
which variable are causing the largest deviations?’[1]

⮚Sensitivity analysis determines the effect on the NPW of variations in

the input variables (such as revenues, expenses, investment, salvage
value etc.) used to estimate after tax cash flow. [2]
 SENSITIVITY ANALYSIS (Cont’d….)

⮚“In Engineering economic studies, sensitivity analysis is a general

non probabilistic methodology, to provide information about the
potential impact of uncertainty in selected factor estimates”. [3]

⮚A Financial Sensitivity Analysis, also known as a What-If analysis

or a What-If simulation exercise, is most commonly used by
financial analysts to predict the outcome of a specific action when
performed under certain conditions. [4]
 SENSITIVITY ANALYSIS (Cont’d….)

For example:
⮚What if the investment increases by 20% of the initial
investment, what will be the PW/IRR?
⮚What if the net annual revenue decreases by 10%, what will be
the changes in the PW/IRR?
⮚What if the useful life increases by 15%, what will be the
changes in PW/IRR ?
Sensitivity analysis tries to answer these questions and is
considered as what if analysis.
 STEPS FOR SENSITIVITY ANALYSIS

⮚It begins with the base case situation, which is developed using the
most likely values for each input. Develop the prime equation.

⮚Justify the project economically.

⮚Change the specific variable of interest by several specified

percentages above and below the most – likely value, while holding
other variables constant.

⮚Calculate a new PW/FW/AW/IRR/BCR for each of these values.

STEPS FOR SENSITIVITY ANALYSIS (Cont’d….)

⮚Present the results of a sensitivity analysis in the

sensitivity graph.

⮚The slope of the line shows how sensitive the NPW is to

changes in each of the inputs.

⮚The steeper the slope, the more the sensitive the NPW is
to change in a particular variable
SENSITIVITY ANALYSIS (Cont’d….)
Interpretation of Sensitivity Graph
⮚On a plot, there are two directions to measure uncertainty:
▪ On X-axis, the uncertainty in the input variable is measured.
▪ On Y-axis, the impact of that uncertainty on PW is measured.
⮚The slope of the line shows how sensitive the PW is to change
in each of the inputs. The steeper the slope, the more sensitive
the PW is to a change in a particular variable.
⮚The graph allows us to identify the crucial variables that
most affect the final outcome
SENSITIVITY ANALYSIS (Cont’d….)

⮚A properly drawn spider plot shows the following:

▪ Limits of uncertainty for each cash flow element.

▪ Impact of each cash flow element on the PW or IRR (each
can be used as Y-axis)
▪ Identification of each cash flow element that might change
the recommendation.
 Example [3]
Perform the Sensitivity Analysis using the PW formulation over a
range of ±40% changes in the estimates for –
1. Capital Investment (I)
2. Annual net Cash flow (A)
3. Market value (MV)
4. Useful life (N)
Based on these best estimates, plot a diagram that summarizes
the sensitivity of present worth to percent deviation changes in
each separate factor estimate when MARR =10% per year
Example (Cont’d…..)

Capital Investment (I) - $ 11,500

Revenues / yr $ 5,000
Expenses / yr - $ 2,000
Market Value (MV) $ 1,000
Useful Life (N) 6 years
 Example (Cont’d…..)
Step 1
⮚ Developing base case situation i.e. The PW of the project on the best
estimate of the given factors is
Prime Equation
PW (10%) = - $ 11,500 + $ 3,000 (P/A , 10% , 6) + $ 1,000 (P/F,10%,6)
= $ 2,130 > 0 (economically accepted)
Step 2
When the capital Investment (I) varies with the increment of 10% up
to ±40%)
PW (10%) = - $ 11,500 (1 ±p% ) +$ 3,000 (P/A , 10% , 6) + $ 1,000
(P/F,10%,6)
 Example (Cont’d…..)

For + 10%, PW (10%) = +$980 For - 10%, PW (10%) = +$3280

For + 20%, PW (10%) = - $170 For - 20%, PW (10%) = +$4430
For - 30%, PW (10%) = +$5580
For + 30%, PW (10%) = -$1320
For - 40%, PW (10%) = +$6730
For + 40%, PW (10%) = -$2470

Step 3
When the Annual Cash Flow (A) varies with the increment of
10% up to ±40%)
PW (10%) = - $ 11,500 + $ 3,000 (1 ±p%) (P/A , 10% , 6) + $ 1,000
(P/F,10%,6)
 Example (Cont’d…..)

For + 10%, PW (10%) = +$3,436 For - 10%, PW (10%) = +$823.42

For + 20%, PW (10%) = +$4743 For - 20%, PW (10%) = -$483.16
For + 30%, PW (10%) = +$6049 For - 30%, PW (10%) = -$1789.74
For + 40%, PW (10%) = +$7356 For - 40%, PW (10%) = -$3096.32
Step 4
When the Salvage Value (SV) varies with the increment of 10% up
to ±40%
PW (10%) = - $ 11,500 + $ 3,000 (P/A , 10% , 6) + $ 1,000 (1 ±p%)
(P/F,10%,6)
Example (Cont’d…..)

For + 10%, PW (10%) = +$2,186.44

For + 20%, PW (10%) = +$2243
For + 30%, PW (10%) = +$2299
For + 40%, PW (10%) = +$2356.04

For - 10%, PW (10%) = +$2073.56

For - 20%, PW (10%) = +$2017.12
For - 30%, PW (10%) = +$1960.68
For - 40%, PW (10%) = +$1904.24
 Example (Cont’d…..)
Step 5
When the useful life (N) varies with the increment of 10% up to ±40%
PW (10%) = - $ 11,500 + $ 3,000 {P/A , 10% , 6 (1 ±p%) }
+ $ 1,000 {P/F,10%, 6(1 ±p%) }
For + 10%, N=6.6 PW (10%) = +$3040
For + 20%, N=7.2 PW (10%) = +$3900
For + 30%, N=7.8 PW (10%) = +$4710
For + 40%, N=8.4 PW (10%) = +$5477
For - 10%, N=5.4 PW (10%) = +$1167
For - 20%, N=4.8 PW (10%) = +$147
For - 30%, N=4.2 PW (10%) = -$933
For - 40%, N=3.6 PW (10%) = -$2077
 Example (Cont’d…..)

Present Worth (PW)

- 40% -30% -20% -10% 0% +10% + 20% +30% + 40%

I ($)
6730 5,580 4430 3,280 980 - 170 -1320 - 2,470
2,130
A ($)
-3,096.32 -1,789.74 - 483.16 823.42 3,436.58 4,743 6,049.74
2,130 7356.32
SV($)
1,904.24 1,960.68 2,017.12 2,073.56 2,186.44 2,243 2,299 2,356
2,130
N ($)
- 2,786 -933 147 1167 3040 3,900 4,710 5,477
2,130

Plotting these values in the sensitivity graph

Step 6 Sensitivity Graph (Spider plot) Of Four Factors
PW (10%)
Ca
pi
ta 7000
lI
nv
es 6000 w,A
tm
en Fl o N
t,
I
5000 ash Li fe,
etC eful
4000 lN Us
nua
3000 An Val ue, MV
$2130 Ma rket
2000
+%Deviation
-% Deviation 1000 Changes in
Changes in
Factor
Factor 0 +10 +20 +30 +40
- 40 -30 -20 -10 Estimate
Estimate
-1000
-2000
-3000

-4000
 Example (Cont’d…..)
Step 7 Revelations Of Spider plot
⮚ Shows the sensitivity of the present worth to percent deviation
changes in each factor’s best estimate
⮚ Other factors are assumed to remain at their best estimate
values
⮚ The relative degree of sensitivity of the present worth to each
factor is indicated by the slope of the curves (the “steeper” the
slope of a curve the more sensitive the present worth is to the
factor)
⮚ In this example:
Present worth is insensitive to MV and N
Present worth is sensitive to I, A,
 Decision Tree Analysis

⮚ Alternative evaluation may require a series of decisions where

the outcome from one stage is important to the next stage of
decision making.
⮚ When each alternative is clearly defined and probability
estimates can be made to account for risk, it is helpful to
perform the evaluation using decision tree. [5]
⮚ A decision tree is a flowchart that starts with one main idea
and then branches out based on the consequences of your
decisions.
 Decision Tree Analysis

⮚Decision tree is a powerful means of facilitating the analysis of

important problems, especially those that involve sequential
decisions and variable outcomes over time. [3]
⮚It’s called a “decision tree” because the model typically looks
like a tree with branches. [6]
⮚In short, decision tree is the graphic representation of various
alternative solutions that are available to solve a given
problem, in order to determine the most effective courses of
action. [7]
Decision Tree Analysis (Cont’d….)

A decision tree includes: [5]

⮚More than one stage of alternative selection.
⮚Selection of an alternative at one stage that leads to another
stage.
⮚Expected results from a decision at each stage.
⮚Probability estimates for each outcome.
⮚Estimate of economic value (cost or revenue) for each outcome.
⮚Measure of worth as the selection criterion such as E(PW).
 Decision Tree Analysis (Cont’d….)
Components of Decision Tree
The decision tree is constructed left to right and includes each
possible decision and outcome.
• Decision node: A square represents a decision node for
making decision by a decision maker.
• Branch: It is a line connecting nodes from the left to the right
of the diagram.
• Probability node (chance node) : A circle represents
probability node with the possible outcomes and estimated
probabilities on the branches.
Decision Tree Analysis (Cont’d….)

Source: [5]
 Decision Tree Analysis (Cont’d….)

For the Evaluation and Selection of the alternative, the following

information is necessary. [5]

⮚The probability that is estimated must sum to 1.0 for each set
of outcomes (branches) that results from decision.

⮚Economic information for each decision alternative and

possible outcome, such as initial investment and estimated cash
flows.
 Decision Tree Analysis (Cont’d….)
Procedure for Solving Decision Tree Using PW analysis
⮚Start at the top right of the tree. Determine the PW value for each
outcome branch.
⮚Calculate the Expected value for each decision alternative
⮚ E (decision) = Σ (outcome estimate) P (outcome)
⮚At each decision node, select the best E (decision) value –
minimum cost or maximum value (if both cost and revenues are
estimated).
⮚Continue moving to the left of the tree to the root decision in order
to select the best alternative.
Decision Tree Example
A company is planning for its plants by investing $ 3,60,000.
Estimates for efficiency of design goals, their probabilities and
corresponding annual expenses saving are as follows:
Design goal met (%) Probability Annual expenses saving ($)
85 0.35 40,000
60 0.50 33,000
50 0.15 26,000

The Company has another option to invest this money that

earns 20% per year elsewhere. Based on the Expected PW as
the decision criterion, determine whether the mechanizing is
preferable or not? MARR = 12% and analysis period is 5
years.
Decision Tree Example (Cont’d…..)
The PW corresponding to each efficiency goals are :
• PW (12%) 85 = - 3,60,000 + 40,000 (P/A, 12%, 5 ) = - $ 2,15,808
• PW (12%) 60 = - 3,60,000 + 33,000 (P/A, 12%, 5 ) = - $ 2,41,042
• PW (12%) 50 = - 3,60,000 + 26,000 (P/A, 12%, 5 ) = - $ 2,66,275

For Option 2 (Invest elsewhere that earns 20% per year)

• Annual earning = (0.2 * 3,60,000) = $ 72,000
• PW (12%) = - 3,60,000 + 72,000 (P/A, 12%, 5 ) = - $ 1,00,454
Decision Tree Example (Cont’d…..)
Probability Annual
Saving Present worth (12%)
85 : 0.35 40,000 - $ 215808
Mechanize 60 : 0.50 33,000 - $ 241042
D1
50 : 0.15 26,000 - $ 266275

D
D2 - $ 100454
Elsewhere 12% rate of return

The single stage decision tree diagram

 Decision Tree Example (Cont’d…..)
Expected PW
For option 1
E (PW) = - 215808 (0.35) +(– 241042) ( 0.50) + (– 266275) (0.15)
= - $ 2,35,995
For Option 2
E (PW) = - $ 100454
The analysis indicates that none of the options are preferable and
even if we make the decision, the option 2 should be selected.
 Scenario Analysis

⮚It is also called the Optimistic- pessimistic – most likely

estimation.
⮚Sensitivity and break even analysis is useful to show the effect
of one common variable and NPW.
⮚In reality there may be difficult to specify precisely the
relationship between a particular variable and the NPW
because there may be interdependence between the variable. [8]
⮚Hence the relationship is further complicated by inter
dependencies among the variables at a time.
 Scenario Analysis (Cont’d…)

• Scenario analysis is the technique that considers the

sensitivity of NPW due to change in key variables at a time
and the range of likely value of those variables.
• For example, the decision maker may examine three extreme
cases i.e. best case scenario, worst case scenario and the most
likely scenario.
• The NPWs under the worse and the best scenarios are then
calculated and compared with the expected (or base case)
NPW.
 Risk Adjust MARR
⮚Uncertainty causes factors inherent to engineering economy
studies, such as cash flows and project life, to become random
variables in the analysis.
⮚A widely used industrial practice for including some
consideration of uncertainty is to increase the MARR when a
project is thought to relatively uncertain.
⮚Hence a procedure has emerged that employs risk adjust
interest rates.
⮚If two or more investments delivered the same return over a
given time period, the one that has the lowest risk will have a
better risk-adjusted return. [9]
 References:

[1]
https://www.slideshare.net/lashinialahendra/sensitivity-analys
is
(Viewed November 2022)

[2] Contemporary Engineering Economics, Chan S. Park

Second Edition, Addison-Wesley Publishing Company, 1997.

[3] Engineering Economy: William G. Sullivan, James A.

Bontadelli & Elin M. Wicks, Eleventh Edition, Pearson
Educations, Inc. 2000
 References (Cont’d….)

[4]
https: //corporatefinanceinstitute.com /resources / knowledge /
modeling /what-is-sensitivity-analysis
(Viewed November 2022)
[5]Engineering Economy: Leland Blank and Anthony Tarquin,
International Fifth Edition, Tata McGraw Hill Company Inc.
2002.
[6] https://asana.com/resources/decision-tree-analysis (Viewed
November 2022)
[7]
https://www.heavy.ai/technical-glossary/decision-tree-analysis
References (Cont’d….)

[8] A Textbook of Engineering Economics : Damodar

Adhikari, First Edition, Dreamland Publication Pvt. Ltd.
Kathmandu, Nepal, 2019.
[9]
https : // www.investopedia.com / terms /r / riskadjustedretur
n.asp
(Viewed November 2022)