Sensitivity and Risk Analysis

Sensitivity and Risk Analysis - McGill Faculty of...

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1 McGill Faculty of Engineering MIME 310 Engineering Economy “You should be concerned about the future. .. you’ll be living there for the rest of your life.” , Old Chinese Proverb Sensitivity and risk analysis add a second dimension to decision- making. Chapter 9 – Sensitivity and Risk Analyses Section 1: Overview • Estimates • Definitions of uncertainty and risk Outline Section 2: Sensitivity Analysis • How is it done? • Spider diagrams • Usefulness Section 3: Risk Analysis • Traditional methods of allowing for risk • Role of risk analysis • Decision-making criteria • Risk analysis techniques
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2 McGill Faculty of Engineering MIME 310 Engineering Economy Overview The majority of parameters in project evaluation are “estimates” , i.e. they are uncertain at the time of evaluation. Therefore, the results of the evaluation process are uncertain as well. Section 1: Overview Estimates Estimates are best guesses or most likely values. An estimate is uncertain because: There is incomplete information at the time of evaluation Project parameters are realized in the future, and the investor has no control over them
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3 McGill Faculty of Engineering MIME 310 Engineering Economy Under conditions of uncertainty, investment decisions should be based on: Section 1: Overview Expected value analysis – return that investor expects to get, based on his/her estimates Sensitivity analysis – sensitivity of project performance to variations in estimates Risk analysis – eco nomic risk associated with investment project Definitions Economic Uncertainty – U ncertainty of financial outcome, reflecting uncertainty of estimates Economic Risk – Pos sibility of financial loss due to the possible occurrence of undesirable outcomes
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4 McGill Faculty of Engineering MIME 310 Engineering Economy 15% Project B 20% Project A Most likely IRR (based on estimates) 90% Project B 60% Project A Probability of Success Project A, with the highest rate of return is preferred. The risk-averse investor would choose B The risk-taking investor would choose A The Need for Another Criterion… Which project is preferred? Section 1: Overview Suppose two projects with equal lives and initial in- vestments having rates of return as shown. Now, add information on the projects’ probability of success. ..
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5 McGill Faculty of Engineering MIME 310 Engineering Economy Section 2: Sensitivity Analysis • How is it done? • Spider diagrams • Usefulness Section 1: Overview • Estimates • Definitions of uncertainty and risk Outline Chapter 9 – Sensitivity and Risk Analyses P Section 3: Risk Analysis • Traditional methods of allowing for risk • Role of risk analysis • Decision-making criteria • Risk analysis techniques
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6 McGill Faculty of Engineering MIME 310 Engineering Economy Sensitivity Analysis Measures the effect of variations in project parameters on investment decision criteria Section 2: Sensitivity Analysis The most common form examines the effect of one parameter at a time
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Sensitivity and Risk Analysis - McGill Faculty of...

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