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Solutions Chapter 5

# Solutions Chapter 5 - 67 Solutions 5.1 Sensitivity analysis...

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Unformatted text preview: 67 Solutions 5.1. Sensitivity analysis answers the question “What matters in this decision?” Or, “How do the results change if one or more inputs change?” To ask it still another way, “How much do the inputs have to change before the decision changes?” We have framed the main issue in sensitivity analysis as “What matters” because of our focus on constructing a requisite model. Clearly, if a decision is insensitive to an input—the decision does not change as the input is varied over a reasonable range—then variation in that input does not matter. An adequate model will fix such an input at a “best guess” level and proceed. 5.2. This is a rather amorphous question. The decision apparently is, “In which house shall we live?” Important variables are the value of the current home, costs of moving, purchase price, financing arrangements (for the current house as well as for a new one), date of the move, transportation costs, and so on. What role would sensitivity analysis play? The couple might ask whether the decision would change if they took steps to reduce driving time in the future (e.g., by deciding to have no more children). How does the attractiveness of the different alternatives vary as the family’s size and the nature of future outings are varied? (For example, how much more skiing would the family have to do before living out of town is preferred?) Can the family put a price tag on moving into town; that is, is there an amount of money (price, monthly payment, etc.) such that if a house in town costs more than this amount, the family would prefer to stay in the country? 5.3. Another rather amorphous question. Students may raise such issues as: • Is a retail business the right thing to pursue? (Is the right problem being addressed?) • Does the father really want to be a retailer? • Operating costs and revenues may vary considerably. These categories cover many possible inputs that might be subjected to sensitivity analysis. To use sensitivity analysis in this problem, the first step would be to determine some kind of performance measure (NPV, cash flow, payback, profit). Then a tornado diagram could be constructed showing how the selected performance measure varies over the range of values for the inputs. The tornado diagram will suggest further modeling steps. 5.4. From the discussion in the text, the basic issue is whether some relevant uncertainty could be resolved during the life of the option. Some possibilities include: • Obtaining a new job, promotion, or raise, • Obtaining cash for a down payment, • Learning about one’s preferences. “Is this house right for me?” • Are there hidden defects in the house that will require repairs? • Are there hidden defects in the house that will require repairs?...
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Solutions Chapter 5 - 67 Solutions 5.1 Sensitivity analysis...

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