09 Lecture 9 - Risk and Uncertainty Business decisions are...

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Risk and Uncertainty Business decisions are routinely made on incomplete and inaccurate information. The question is "how accurate does the information have to be to arrive at the correct decision?" This is the area called risk and uncertainty. All engineering economy studies are based on estimates of the future. The estimates are usually accurate to some extent. The only way to know how accurate your estimates are, is to post-audit a number of projects and determine the variance of the estimates from the actual results. Other ways to benchmark estimates is to compare your estimating to previous cases and to similar businesses. In the end, all estimates of future results are forecasts and are subject to potentially wide ranging errors. The goal in engineering economy is to minimize financial risk by proper application of techniques. These techniques will be discussed in this lesson. In my opinion, the title of this chapter should be risk minimization techniques. Breakeven Analysis Up to this point, we have considered each project analysis to be based on one single set of forecasted future results. This is most likely the "best estimate" of the future at the point in time that it was created. We call this the "Base Case." Each project has a base case that represents the best information available at the current moment. A decision to proceed on a project should not be made without further consideration of the question "what if we're wrong about our estimates in the base case?" and "how wrong can our estimate be and still make the project worthwhile?" An examination of the assumptions underlying the estimates and the ranges of values that the parameters may take on is a valuable aid in making correct decisions. For instance, in a typical base case for a project, we know that if the present worth is positive, then the project is justified to proceed because it has an excess return over the MARR. The first question we could ask is "how does parameter x have to change to make the present worth of the project decline to zero?" That is, reduce the project to marginal acceptability. This can easily
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happen when the capital cost of a project rises well above the original estimates, or the prices (and revenues) for the project are less than originally expected. The breakeven technique treats each major estimated parameter as a variable, and then changes its value until the present worth of the project is zero. The result is said to be the breakeven value of that parameter for the project. Two key results are obtained. The first is based on the breakeven value itself. A business judgment may be made as to whether the breakeven value is possible or not within the commercial context of the project. If it is not, then that specific parameter cannot "kill" the project. The second result is the magnitude of the change between the base case value and the breakeven value of the parameter. A business judgment can be made as to whether that magnitude is overly optimistic or pessimistic. This provides
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09 Lecture 9 - Risk and Uncertainty Business decisions are...

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