The University of the West Indies

Faculty of Engineering
Notes for: ENGR1000/MENG1006 - INTRODUCTION TO ENGINEERING
Prepared by Dr T.M.Lewis

FUNDAMENTALS OF ENGINEERING PROJECT ECONOMICS

LECTURE 6

1 Risk and Uncertainty

1.1 The discussion and examples covered so far have all involved evaluating or choosing between
alternatives with a single set of forecasts given. In each case it can be assumed that the
forecasts represent someone's best judgement on the way in which future receipts and
disbursements will be influenced by that particular course of action. However, there is always
uncertainty about the future; it will rarely, if ever, turn out to be just as we forecast it. This does
not mean that we should not use the best forecasts that we can, but it does mean that we should
test the sensitivity of our analyses to changes in different elements of those forecasts.

1.2 Economic analyses of engineering projects require estimates to be made of such cost elements
as, fuel, power, labour, taxes, repairs, maintenance and insurance, and of such income elements
as sales revenues, salvage values and savings, as well as of the future interest and inflation
rates and the 'economic life' of the project. All of these factors have a bearing on the outcome of
the analysis. It is obvious in some cases that relatively minor changes in one of these factors
would have changed the recommended course of action, whilst in others, the recommendation is
robust against relatively large changes in the same factors.

1.3 'Sensitivity' is the term used to refer to the relative magnitude of the change in one or more
elements in the economic analysis of an engineering project that will cause a change in the
decision recommended from amongst the alternatives available. Thus, if one particular element
can be varied over a wide range of values without affecting the decision, the decision under
consideration is said not to be sensitive to uncertainties regarding that particular element.

1.4 Example:
A company has to provide a heat source for an electro-chemical process, and can choose
between using a coal fired system and oil fired system and an electrically heated system. The
costs of the different systems are as follows:

Coal fired system Oil fired system Electricity

Annual investment $623.75 $397.23 $119.45
charge
Unit cost of fuel $1.23/KWh $1.97/KWh $2.44/KWh
Annual fuel cost $615.00 $985.00 $1,220.00
Equivalent annual $1,238.75 $1,382.23 $1,339.45
cost

1.5 In the table, the capital cost of each system has been reduced to an annuity over the life of the
system, and is given as an 'annual investment charge'. The fuel charge is based on an average
annual demand of 500 kilowatt hours (KWh). The economic analysis suggests that the coal fired
system would be the cheapest.

However, the relative costs of the different fuels are given here as their best estimates. In order
to look at the sensitivity of this decision to the cost of fuel, it is necessary to look at the estimates
 of their prospective prices. It is felt that the price of coal may fall within a band of prices of
between $1.20 - $1.45 per KWh, Oil between $1.80 - $2.00 per KWh and electricity between
$2.44 - $2.60 per KWh. What does this mean?

Sensitivity analysis - Equivalent annual cost ($)

Coal Oil Electricity
Low Best High Low Best High Low Best High
1,223.75 1,238.75 1,348.75 1,297.23 1,382.23 1,397.23 1,339.45 1,339.45 1,419.45

1.6 It can be seen from the figures in this 'sensitivity analysis' table that the decision is sensitive to
the estimates of the future cost of fuel. If the cost of coal is at the high end of the scale, and the
cost of oil at the low end then the choice would change to using oil, and if both coal and oil were
at the high ends of their scales then the choice would switch to using electricity.

2 Expected Values
2.1 Because events are often either difficult or impossible to predict in advance it is often necessary
to introduce the concepts of uncertainty or risk into the analysis. For the purposes of economic
analysis the terms are used slightly differently from one another. In simple terms:
• risk is specified or quantified uncertainty. A risk is said to exist if a particular event
is unpredictable, but we can nevertheless specify the various outcomes that could
arise, and attach a measure of likelihood or probability to each of these outcomes.
• Uncertainty is present when the unknown outcomes cannot even be predicted in
probabilistic terms.

The essential point is that when a risk exists one can still act rationally by evaluating the
probabilities of different outcomes and taking that course of action which has the highest
beneficial expectation.

2.2 There is, for example, an obvious risk involved in betting on the toss of a coin. Clearly the
possible outcomes are known, and their probabilities of occurrence are also known. It is also
possible to evaluate a decision in such circumstances in term of its expected monetary value.
The principle of 'expectation' is based on 'utility theory', which states that the expected utility of
any decision can be obtained by multiplying the average utility (cost, revenue or other variable)
of each of the prospective outcomes by its probability of occurring. The decision which
maximises this expected utility should be taken.

2.3 Thus, if the probability that a cost of $1,000 will occur is 40% (0.4), then its expected value is
$1,000 x 0.4 = $400.

If there is more than one prospective outcome, then we must compute the sum of the individual
expected values. Hence, if the economic life of a project is estimated to be 10 years with a
probability of 0.4, and 15 years with a probability of 0.6, then the expected project life is 10 x 0.4
+ 15 x 0.6 = 13 years

2.4 Thus when betting on the toss of a coin, let us say $1 on a head, if it comes up heads you win, if
not you lose. The expected value of any single toss of the coin is:

0.5x$1.00 + 0.5x$0 = $0.50

2.5 In engineering project terms, the value of an investment can take account of risk in the same
way. Hence, it may be felt that an investment in a plant manufacturing polyethylene has a 25%
 likelihood that the demand will be high, a 45% likelihood that the demand will be average, a 20%
that the demand will be low, and a 10% likelihood that it will be very low. The profit from each
level of demand may be, respectively $1.6m, $750,000, $400,000, and $20,000. What is the
expected value of this investment?

Expected Value = 0.25x$1.6m + 0.45x$750,000 + 0.20x$400,000 + 0.10x$20,000

= $400,000 + $337,500 + $80,000 + $2,000

= $819,500

2.6 Note:
1. The expected value is different from any of the sums of money that will actually be
received. It represents what would be received on average if you made this same choice
thousands of times, and each outcome occurred in proportion to its probability. Thus, on 25
occasions out of every 100, the demand would turn out high and a profit of $1.6m would be
made, on 45 occasions a profit of $750,000 would be made, on 20 occasions a profit of $400,000
would be made and on 10 occasions a profit of $20,000 would be made. Thus, to find the
average of these you would add up all the values and divide by 100 (i.e. $(25x1.6m +
45x750,000 + 20x400,000 + 10x20,000)/100) - and this sum is exactly equivalent to the sum
calculated above - i.e. $819,000. It represents the sum of the probabilities multiplied by their
respective outcomes:

E.V. = Σp.v

where p = the probability of each outcome

and v = the value of each outcome.

2. If the investment would have made a loss when the demand turned out to be low, then
this is simply incorporated into the calculations as a negative value for the losses. Hence if low
demand resulted in a loss of say $100,000 and very low demand resulted in a loss of $500,000,
the calculation would become:

E.V. = 0.25x$1.6m + 0.45x$750,000 + 0.20x(-$100,000) + 0.10x(-$500,000)

= $400,000 + $337,500 - $20,000 - $50,00

= $667,500

3 Game Theory
3.1 The taking of decisions under conditions of uncertainty and risk has been rationalised under the
heading of Game Theory. Game theory, as its name suggests, has the purpose of attempting to
model uncertain or risky decisions as if they represented a scenario in a game, in order to
determine the optimum action to take in any specific set of risky circumstances that may arise in
that scenario. The optimum outcome is ascertained by working through all the possibilities,
checking them against their sensitivities, and evaluating their outcomes

3.2 Thus, there has been a great deal of work done on War Games - to try to determine what the
best policy would be under different circumstances, by evaluating all the outcomes and choosing
the course of action that gives the most favourable results.
3.3 Many aspects of engineering involve dealing with uncertainty and risk, and these situations can
normally be modelled using 'gaming' techniques, and these techniques can help to determine
what the best strategy would be in any specific circumstances. The principles of game theory and
expectation can also be incorporated into other techniques, like economic evaluation and
cost/benefit analysis, to improve their comprehensiveness.