1

UNIT 6: Risk Analysis (6 hrs)

Introduction:
Risk:
 Risk is the potential of gaining or losing something of value.
 It is the possibility that an actual return on an investment will be lower than
expected return.
 Risk may be defined as lower incomes or higher expenditure than expected.
Uncertainty: Decision making under uncertainty means there are two or more values
observable but the chance of their occurring cannot be predicted.
Difference between risk and uncertainty
Risk Uncertainty
Risk can be measured Cannot be measured
Outcome known Outcome unknown
Controllable Uncontrollable
Minimized Can't be minimized

Risk analysis is a technique used to identify and evaluate factors that may put at risk the success
of project or achieving goal. It is the process of defining and analyzing the danger to individuals,
businesses and government agencies posed by potential natural and human-caused adverse
events.
Sources of Project Risks:
Both risk and uncertainty in decision making activities are caused by the lack of precise
knowledge regarding future business condition, technological development, market demand and
so on. There are four major sources of risk and uncertainty of risk and uncertainty that affect
project's NPW i.e. engineering economy studies.
i. Cash flow estimate: The first source is the possible inaccuracy of the cash flow estimates
used in the study. The accuracy of the cash-inflow estimate is difficult to determine. If they
are based on past experience, a fair degree of reliance may be placed on estimates.
Otherwise, the estimate would become more uncertain.
ii. Nature of business
Another source of risk and uncertainty is possible if the type of business involved in the
economy. All businesses are not of same nature because some types of business operations
are less stable than others. For example, mining enterprises/projects are more risky than
farming projects with the expectation of stability and income generation.
iii. Rate of interest/ rate of inflation:
Current health of economy and future expectations of economic conditions are responsible
for determining market rate of interest and its stability. Hence, whenever capital is to be
invested in an engineering project, an investor should be considered in deciding what risk
percent on rate of interest?
iv. Study period:
Another risk source is the length of study period used in the analysis. A long study period
naturally decreases the probability of all the factors as estimated i.e. long study period
generally increases the uncertainty of capital investment and economic return.
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Methods of Project Risks: There are three methods for describing project risk.

 Break-Even Analysis
 Sensitivity Analysis
 Scenario Analysis

 Breakeven Analysis: One of the most common tool used in evaluating the economic feasibility/
evaluation of new enterprise or product is the Break-Even Analysis. The main objective of Break-
Even Analysis is to find out the condition of no loss and no gain. When one of the engineering
economy symbols- P, F, A, I or n is not known or not estimated, a break even quantity can be
determined by setting an equivalent relation for PW or AW equal to zero. When the equivalent worth
of cash inflows and outflows are dependent upon a single factor (parameter), the value of this factor
for which equivalent worth of cash outflows equals the equivalent worth of cash inflows is called
breakeven point and its analysis is called breakeven point analysis.
 Break-Even Analysis for a Single Project
The costs of producing a good can be split into two main parts.
Fixed costs (CF)
Fixed costs are those that remain the same for the firm however many goods produced. All start-up
costs such as land, building, rent, insurance, equipment etc are considered as fixed costs we have to
make these outlays before we sell our first item.
Variable costs (CV)
Variable costs vary with the number of items produced. So, these are recurring costs that we absorb
with each unit produce or sell. It includes cost of wages, raw materials, electric, fuel, advertise etc.
Variable cost changes with production level, workforce size and other parameters.

Cost and Revenue

Break-even point
Total Sales

QBEP Profit Total Cost

BEPSales
Variable cost
Fixed Cost

Loss

BEPQ Production (Q)

Fig: Breakeven Analysis
Let,
s be the selling price per unit.
v be the variable cost per unit.
FC is the fixed cost per unit.
Q is the quantity of production.
Total sales(S) = s*Q.........(i)
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Total cost of Firm (TC) = Variable cost + Fixed cost

(TC) = v*Q + FC..................... (ii)
Linear plot of these two equations is given in the figure above. The intersection point of the total sales
revenues and the total cost line is called the breakeven point. At the intersection point the total cost is
equal to total revenue and is the condition of no loss or no gain.
Total Cost = Total Sales
Variable cost + fixed cost = s*Q
or, v*Q + FC =s*Q
or, FC = (s*Q –v*Q)
or, Q =

or, QBEP = (units)

From above relation, to reach a break-even position the selling price has to be greater than the variable
cost per unit. At the break-even point, the organization will neither make profit nor incur any loss.
If the output volume for the time period is greater than QBEP, a profit will result. Similarly, when
the output volume is less than QBEP, a loss from operation will be incurred by the organization.

Example: A company produces an electronic timing switch that is used in consumer and commercial
products made by several other manufacturing firms. The fixed cost and the total cost are Rs. 40,000 and
Rs. 85,000 respectively. The total sales are Rs 105, 000 and sales volume is 15,000 for this situation.
a) Find breakeven point in terms of number of units.
b) What should be the output if the profit desired is Rs. 50,000?
Solution:
Given,
Fixed cost (FC) = Rs 40,000
Total cost (TC) = Rs 85,000
Total sales(S) = Rs 105,000
Sales volume = 15,000
Breakeven point (QBEP) =?
Quantity (Q) =? (If profit = Rs 50,000)
a) Finding the Breakeven point in terms of number of units
We know,
Total cost (TC) = Fixed cost(FC) + Variable cost(VC)
VC = 85,000-40,000 = Rs. 45,000
Variable cost per unit (v) = 45,000/15,000 = Rs 3per unit
Selling cost per unit(s) = 105,000/15,000 = Rs 7 per unit
QBEP = (units)

QBEP =
QBEP = 10,000 units
b) If the profit desired is Rs 50,000
Profit = Total sales – Total cost
50,000 = s*Q – (FC + v*Q)
50,000 + FC = Q(s-v)
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50,000 + 40,000 = Q (7-3)

Q = 90,000/4 = 22500
For making profit Rs 50,000 is 22, 500 units should be produced (Ans)

Example:
Suppose fixed cost associated with the production of a product is Rs. 5, 00,000. Assume that the variable
cost is Rs. 20,000 and the selling price is Rs. 30,000 for each product and maximum sales amount is Rs.
30, 00,000 when sales volume is 100 units. Determine the break-even point for this situation and plot the
BEP chart.
Solution:
Fixed cost (FC) =Rs 5, 00,000
Variable cost (v) = Rs 20,000 per unit
Selling price (s) = Rs 30,000 per unit
Break-even point BEP =?
Total cost = FC + Q*v
= 5, 00,000 + 100x20, 000
= 5, 00,000 + 20, 00,000
=Rs 25, 00,000
Total sales = s*Q = 30,000 *100 =Rs 30, 00,000
QBEP = FC/(s-v) = 5, 00,000/ (30,000-20,000)
= 50 units Total
For 50 unit total sales = 30,000*50 = Rs 15, 00,000 Sales
Total cost = 5, 00,000 + 20,000 *50 30
Total
= Rs 15, 00,000
Cost and Revenue (00,000)

Cost
25

20

15 BEP

10
Fixed
5 Cost

0 100
QBEP =50 units

Production units

 Break-even Analysis for comparing two alternatives:

When there are two investment opportunities under consideration and heavily dependent on a single and
common factor, we can solve for the value of that factor by equating equivalent worth at which the
conclusion is standoff. That value is known as the Break-Even point i.e. the value at which we are
indifferent between the two alternatives.
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In mathematical terms
EWA = f1(y) and EWB = f2(y)
Where, EWA = equivalent worth calculation for the net cash flow of alternatives A and
EWB = equivalent worth calculation for the net cash flow of alternatives B
y = A common factor affecting the equipment worth values of alternatives A and alternative B.
Break-Even point is the value of y for which f1(y) = f2(y)
Examples of common factors:
1. Annual revenue and expenses
2. Rate of return
3. Salvage Value
4. Equipment life
5. Capacity utilization
Steps To Determine Break-Even Point Of Common Variable:
 Define the common variable and its dimensional units.
 Use PW or AW analysis to express the total cost of each alternative as a function of the common
variable.
 Equate the two relations to solve for the break-even value of the variable.
 If the anticipated (k"jf{g'dflgt) level is below than break-even value, select alternative with the
higher variable cost(larger slope). If the anticipated level is above than break even value, select
alternative with lower variable cost (Smaller slope). Total cost of A

Total cost of B
BEP

Select 'B'
Total cost

Break even time

Select 'A'

Operation time (hour)

Break even analysis of mutually exclusive project
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Example:
Following information has been obtained regarding two motors:
Standard Motor New model motor
Size 100hp 120hp
Cost (Rs) 1,30,000 1,56,000
Life (Yrs) 20 20
Salvage value (Rs) 0 0
Efficiency 89.5% 93%
Annual maintenance cost 8000 2500
Electricity cost Rs. 6/kwh Rs. 6/kwh
Annual tax and insurance 2% of investment
i) At what operating hours are they equivalent?
ii) If the motors have to be operated 38 hrs a year, which one should be selected? Take MARR = 10%
per year.
Solution:
We know that,

1) This gives,
=
For standard motor:
Capital recovery cost = I (A/P, 10%, 20) = 130000(A/P, 10%, 20) = Rs. 15275
Input power = = 83.35kW
Assume both motors are operated X hrs a year.
Operating cost for X hours of operation in a year = 83.35* X *6 = 500.11X
Maintenance cost = Rs. 8000
Tax and insurance = 2% of 130000 = Rs 2600
Total annual cost:
=15275 + 500.11X + 8000 + 2600
= 25875 + 500.1X
For new model motor
Capital recovery cost = I(A/P, 10%, 20) = 1,56,000(A/P, 10%, 20)
= Rs 18330
Input power = = 96.26kW
Operating cost for X hours of operation in a year = 96.26 * X * 6 = 577.55X
Maintenance cost = Rs 2500
Tax and insurance = 2% of 156000 = Rs 3120
Standard
Total annual cost:
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=18330 + 577.55X + 2500 + 3120

= 23950 + 577.55X
Two motors are said to be equivalent only when
25875 + 500.1X =23950 + 577.55X
or, X = 24.875 hrs
Breakeven point is 24.857 hrs.
Example: Consider the following two motors each of 100hp output capacity.
If we are to operate 38 hours a year, standard Motor
Item motor would
A be selected Motor B
as Purchase
shown in cost(Rs)
the figure above. 1,25,000 1,60,000Annual operation hours
Efficiency( 74% 92%
Life(Years) 10 10
Maintenance cost(Rs)/ Year 5,000 2500
Annual tax and insurance % of investment
MARR 15%
a) How many hours per year would the motors have to be operated at full load for the annual costs to be
equal? If electricity cost is Rs 5/kwhr.
b) If annual operation is more than 55 hours, which motor should be selected?
Solution: For motor A
Calculating the annual equivalent cost
1. Capital recovery (CR) cost = I(A/P, 15%, 10) [A/P, i%, N] =
=1, 25,000(A/P, 15%, 10)
= Rs 1, 25,000*0.1993
= Rs24, 912.5
2. Maintenance cost = Rs 5000
3. Tax and insurance = 1.5% of 1,25,000
= 1.5 *1, 25,000/100
=Rs 1,875
Net model
4. Operating expenses for power(electricity)
We have, Annual costs

=
Let 'X' be the number of hours of operation per year
25875
Operating expenses = Input *Rate* hours of operation
= x5xX= x5xX
Select standard
= 504.05X 23950
Total annual cost for motor A i.e. (AW of A)
= Rs 24,912.5 + Rs 5000 + Rs 1875 + 504.05X
= RS 31,787.5 + 504.05X
For motor B
Calculating the annual equivalent cost
 Capital recovery (CR) cost = I(A/P, 15%, 10) [A/P, i%, N] =
=1, 60,000(A/P, 15%, 10)
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= Rs 1, 60,000*0.1993
= Rs31, 888
 Maintenance cost = Rs 2500
 Tax and insurance = 1.5% of 1,60,000
= 1.5 *1, 60,000/100
=Rs 2,400
 Operating expenses for power(electricity)
We have,
=
Let 'X' be the number of hours of operation per year
Operating expenses = Input *Rate* hours of operation
= x5xX= x5xX
= 405.43X
Total annual cost for motor B i.e. (AW of B)
= Rs 31, 888+ Rs 2500 + Rs 2400 + 405.43X
= RS 36,788 + 405.43X
To get the break-even point
AW of A = AW of B
Or, RS 31,781.5 + 504.05X = RS 36,788 + 405.43X
Or, 504.05X – 405.43X = 36,788 - 31,781.5
Or, 98.62X = 5006.5
Or, X = = 50.76 51 hours (Break-even hour)

Total cost of motor A

Total annual cost

Total cost of motor B

36788
Select motor B
31781 Select motor A

Break-even point

0 10 20 30 40 50 60 70
Operation hour per year
If annual operation is more than 55 hours, motor B is selected.
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Example:
Suppose that there are two alternative electric motors that provide 100-hp output.
Item Alpha motor Beta motor
Purchase cost Rs 12,500 Rs 16,000
Efficiency 74% 92%
Maintenance cost Rs 500 per year Rs 250 per year
Life 10 Years 10 Years
Life tax & insurance 1.5 % of the investment
MARR 15%
a) How many hours per year would the motors have to be operated at full load for the annual cost to be
equal?
b) If annual operation hour is 600 hrs, which motor should be selected?
Solution: a) Alpha motor
Calculating the annual equivalent cost
2) Capital recovery(CR)
= I(A/P, i%, N) – S(A/F, i%, N) (when salvage value is given)
= Rs12, 500(A/P, 15%, 10) – 0 (Because salvage value is not given)
= 12,500 *0.1993
= Rs 2491 per year
3) Maintenance Cost
= Rs 500 per year
3) Tax and insurance
= 1.5% of initial investment
= 1.5% of 12,500 = Rs 187.5 Rs 188 per year.
4) Operating expenses for power(electricity cost)
Let 'X' be the number of hours of operation per year
We have,
=
Operating expenses = Input *Rate* hours of operation
= {(100)*0.746} /0.74}*0.05*X
= 5.04X per year
Total annual equivalent cost for Alpha motor i.e. (AW of Alpha Motor)
= Rs 2,491+Rs 500 + Rs 187 + Rs 5.04X
=Rs 3178+ Rs 5.04X.............................(i)
b) Beta motor
Calculating the annual equivalent cost
4) Capital recovery(CR)
= I(A/P, i%, N) – S(A/F, i%, N) (when salvage value is given)
= Rs16, 000(A/P, 15%, 10) – 0 (Because salvage value is not given)
= 16,000 *0.1993
= Rs 3188.8 per year Rs 3189
5) Maintenance Cost
= Rs 250 per year
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3) Tax and insurance

= 1.5% of initial investment
= 1.5% of 16,000 = Rs 240 per year.
5) Operating expenses for power(electricity cost)
Let 'X' be the number of hours of operation per year
We have,

=
Operating expenses = Input *Rate* hours of operation
= {(100)*0.746} /0.92}*0.05*X
= 4.05X per year
Total annual equivalent cost for Alpha motor i.e. (AW of Alpha Motor)
= Rs 3,189+Rs 250 + Rs 240 + Rs 4.05X
=Rs 3679+ Rs 4.05X.............................(ii)
At the breakeven point,
AWCAlpha = AWCBeta
Or, Rs 3178+ Rs 5.04X = Rs 3679+ Rs 4.05X
Or, Rs 5.04X - Rs 4.05X = 3679 – Rs 3178
Or, 0.99X = 501
Or, X = = 506 hour per year
If the operation hour is 600 hrs per year,
AWCAlpha = Rs 3178+ Rs 5.04X = Rs 3178+ Rs 5.04*600 =Rs 6,202
AWCBeta = Rs 3679+ Rs 4.05X = Rs 3679+ Rs 4.05*600 = Rs6,109
Total annual worth(AW in Rs)

Total cost of motor Alpha = Rs 6202

Total cost of motor B =Rs 6109

3680
Select Beta
3177 Select Alpha

Break-even point

0 100 200 300 400 500 600 700 800 900

Operation hour per year
If annual operation is 600 hours, motor Beta is selected.
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 Sensitivity Analysis:
 Sensitivity analysis is a technique which allows an analysis of changes of assumptions
used in forecasts.
 Sensitivity analysis means analysis of various factors in relation to project i.e. cost of project,
life of project, cost of capital, selling price of product, cost of product etc.
 In sensitivity analysis, we change each factor in unfavorable direction, keeping other factors
constant. This helps us to identity critical factor such that further research may carry out
about such factor before accepting the project.
 The biggest drawback of sensitivity analysis is an assumption of factors independently but
factors are dependent on each other, it is not logical to change quantity but keep the selling
price constant.
 A convenient and useful way to present the results of a sensitivity analysis is to plot
sensitivity graph. The slopes of the lines show how sensitive the NPW is to changes in each
of the inputs. The steeper the slope, the more sensitive the NPW is to change in a particular
variable. Sensitivity graph identifies the crucial variables that affect the final outcome most.

Steps for sensitivity analysis

 It begins with the base case situation, which is developed using the most likely values for
each input.
 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.
 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.
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 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.
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Example:
Perform sensitivity analysis of the following project over a range of in
a) Initial investment b) annual net revenue c) salvage value d) useful life.
Initial investment (I) = Rs 11,500
Net annual revenue (AR) = Rs 3,000
Salvage value (S) = Rs 1,000
Useful life (N) = 6 years
MARR = 10%
Draw also the sensitivity diagram/graph.
Solution:
PW (10%) = -11,500 + 3,000(P/A, 10%, 6) + 1,000(P/F, 10%, 6)
= -11,500 + 3,000 *4.3553 + 1,000 *0.5645
= -11,500 + 13065.9 + 564.5
= Rs. 2130.4
a) When initial investment (I) varies the PW would be:
At I = +40% ; PW = - 11,500(1.4) + 13,065.9 +564.5 = Rs. -2,470
At I = -40% ; PW = - 11,500(0.6) + 13,065.9 + 564.5 = Rs.6730

b) When the annual revenue(AR) varies the PW would be;

At AR = +40%;
PW (10%) = -11,500 + 3,000(P/A, 10%, 6)*1.4 + 1,000(P/F, 10%, 6)
PW = - 11,500 + 13,065.9(1.4) +564.5 = Rs. 7,356
At AR = -40%; PW = - 11,500 + 13,065.6(0.6) +564.5 = Rs.-3,096

c) When the salvage value(S) varies the PW would be;

At S = +40%; PW = - 11,500 + 13,065.6 +564.5(1.4) = Rs. 2,356
At S = -40%; PW = - 11,500 + 13,065.6 +564.5(0.6) = Rs. 1,904

d) When useful life (N) varies the PW would be;

for N = + 40%; and At N = - 40%.
At N = + 40%;
PW = - 11,500 + 3,000(P/A, 10%, 8.4) +1000(P/F, 10%, 8.4) = Rs.5477.27
At N = - 40%; PW = - 11,500 + 3,000(P/A, 10%, 3.6) +1000(P/F, 10%, 3.6)
= Rs. -2077
For this situation we use formula ] for (P/A, 10%, 11.2)

and S for (P/F, 10%, 11.2)

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Calculation table
Parameters PW (10%)
-40% -20% 0% +20% +40%
I 6730 2130 -2470
AR -3096 2130 7356
S 1904 2130 2356
N -2077 2130 5477.27
+PW (10%)

8000
Annual Revenue (AR) 7356
7000
6730
6000
5476

Initial Investment (I) 5000

Useful life (N)
4000

3000
2130
Salvage value(S) 2356

-40 -30 -20 -10 2000 +10 +20 +30 +40

Salvage value(S) 1904 +% change in parameter
1000
- % change in parameter

-1000

-2077 -2000
-2470

-3096 -3000

-4000

-PW (10%)

From the sensitivity graph, the slope of annual revenue line is found to be the greatest and is more sensitive.
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Example:
Perform sensitivity analysis using PW method over a range of in
(a) Initial investment (b) Net annual revenue (c) Salvage value (d) useful life.
Initial investment (I) = Rs 2, 00,000
Net annual revenue (AR) = Rs 50,000
Annual expenses (Rs) = Rs 5,000
Salvage value (S) = Rs 25,000
Useful life (N) = 10 years
MARR = 12% per year
Draw also the sensitivity graph.

Solution:
Prime equation:
PW (12%) = -200000 + (50000-5000) (P/A, 12%, 10) + 25,000(P/F, 12%, 10)
= -200000 +45000*5.6502 + 25000*0.3220
= Rs. 62309
For fluctuation in:
a) Initial investment
PW (12%) = -200000(1 ) + (50000-5000) (P/A, 12%, 10) + 25,000(P/F, 12%, 10)
At I = +40%; PW = -200000(1.4) + 45000*5.6502 + 25000*0.3220
= -280000 + 254259 + 8050
PW (12%) = Rs. -17691
At I = -40%; PW = -200000(0.6) + 45000*5.6502 + 25000*0.3220
= -120000 + 254259 + 8050
PW (12%) = Rs. 142309
b) When the Net annual revenue(AR) varies the PW would be;
PW = -200000 + (50000-5000) (1 ) (P/A, 12%, 10) + 25,000(P/F, 12%, 10)
At AR =+40% ; variation in net annual revenue
= -200000 + 254259(1.4) + 25000*0.3220
= -200000 + 355962.6 + 8050
PW (12%) =Rs. 164012.6
At AR= -40%; variation in net annual revenue
= -200000 + 254259(0.6) + 25000*0.3220
= -200000 +152549.4 + 8050
PW (12%) = Rs. -39400.6
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c) When the salvage value(S) varies the PW would be;

PW = - 200000 + (50000-5000) (P/A, 12%, 10) + 25,000(1 ) (P/F, 12%, 10)
At S = +40%; variation in salvage value PW would be
= -200000 + (45000) (P/A, 12%, 10) + 25000(1.4)* 5.6502
= -200000 +45000*5.6502 + 25000*1.4*0.3220
= -200000 + 254259 + 11270
PW (12%) =Rs. 65529
At S = -40%; variation in salvage value PW would be
PW = - 200000 + 45000*5.6502 + 25000*0.6*0.3220
= - 200000 + 254259 + 3220
PW (12%) = Rs. 59089
d) When useful life(N) varies the PW would be;
For N = + 40%; year
PW (12%) = -200000 + (50000-5000) (P/A, 12%, 14) + 25,000(P/F, 12%, 14)
PW (12%) = -200000 + 45000 * 6.6282 + 25000*0.2046
PW (12%) = -200000 + 298269+ 5115
PW (12%) = Rs. 103384

At N = - 40% ; year
PW (12%) = -200000 + (50000-5000) (P/A, 12%, 6) + 25,000(P/F, 12%, 6)
PW (12%) = -200000 + 45000 * 4.1114 + 25000*0.5066
PW (12%) = -200000 + 185013 + 12665
PW (12%) = Rs. -2322

Parameters PW (10%)
-40% -20% 0% +20% +40%
I 142309 62309 -17691
AR -39400.6 62309 164012.6
S 59089 62309 65529
N -2322 62309 103384
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2, 00,000
1, 95,000
1, 90,000
1, 85,000
1, 80,000
1, 75,000
1, 70,000
1, 65,000
Net revenue 164012.6
1, 60,000
1, 55,000
1, 50,000
Initial investment (I) 142309 1, 45,000
1, 40,000
1, 35,000
1, 30,000
1, 25,000
1, 20,000
1, 15,000
1, 10,000
1, 05,000
Useful life (N) 103384
100,000
95,000
90,000
85,000
80,000
75,000 62,309
70,000 Salvage value (S) 65529
65,000
-40% -30% -20% -10% 60,000 10% 20% 30% 40%
59089 55,000
50,000 +% change in parameter
-% change in parameter
45,000
-39400.6 40,000
35,000
30,000
25,000
20,000 -17691
15,000
10,000
5,000
-2322 1,000

From the sensitivity graph, the slope of Net annual Revenue line is found to be the greatest and hence is more
sensitive
 17

 Scenario analysis (Optimistic-pessimistic –most likely estimation):

Scenario analysis is a process of analyzing possible future events by considering alternative possible
outcomes. It is a technique that considers that sensitivity of NPW due to change in key variables at a time
and range of likely values of those variables. Scenario analysis differs from sensitivity analysis in that it
allows for changing more than one variable at once while sensitivity analysis measures the effect of
change in one variable while keeping all other factors constant.

Scenario analysis is conducted, to analyze the impacts of possible future events on the system
performance by taking into account several alternative outcomes, i.e., scenarios, and to present different
options for future development paths resulting in varying outcomes and corresponding
implications. Scenario analysis is the process of forecasting the expected value of a performance
indicator, given a time period, occurrence of different situations, and related changes in the values of
system parameters under an uncertain environment. Scenario analysis can be used to estimate the
behavior of the system in response to an unexpected event, and may be utilized to explore the changes in
system performance, in a theoretical best-case (optimistic) or worst-case (pessimistic) scenario. The
occurrence probability and possible impact of a scenario should be considered in tandem to develop a
strategic plan base on scenario analysis results. The major aim is, to analyze the results of the more
extreme outcomes (with high probability and/or more severe impacts), to determine the investment
strategy.

Scenario analysis of an investment would involve the following steps:

 Finding the base case output at the most likely value for each input. For example, when
calculating net present value, use the most likely value for discount rate, cash flows growth, tax rate,
etc.
 Finding the value of the output at the best possible value for each input. In case of calculating net
present value, use the lowest possible discount rate, highest possible growth rate, lowest possible tax
rate, etc. This is the best case scenario.
 Finding the value of the output at the worst possible value for each input. For a net present value
calculation, it would mean the highest possible discount rate, lowest possible cash flow growth rate,
highest possible tax rate, etc. This is the worst case scenario.
 The NPWs, under the worse and the best scenarios are then calculated and compared with the
expected (or base case) NPW.

Example:

Suppose that for an engineering project, the optimistic, most likely and pessimistic estimates are shown
below.

Variable considered Optimistic Most Likely Pessimistic

Capital Investment(Rs) 80000 95000 120000
Useful life(Yrs) 12 10 6
Market value(Rs) 30000 20000 0
Net annual cash flow(Rs) 35000 30000 20000
MARR 12% 12% 12%
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What is the AW for each of the three estimation condition?

Solution:
For optimistic estimate,
AW (12%) = -80000(A/P, 12%, 12) +35000 + 30000(A/F, 12%, 12)
= -80000 * 0.1614 + 35000 + 30000*0.0414
= -12912 + 35000 + 1242
= Rs. 23330
For most likely estimate,
AW (12%) = -95000(A/P, 12%, 10) + 30000 + 20000(A/F, 12%, 10)
= -95000*0.1770 + 30000 + 20000*0.0570
= - 16815 + 30000 + 1140
= Rs. 14325
For pessimistic estimate,
AW (12%) = - 120000(A/P, 12%, 6) + 20000
= -120000 * 0.2432 + 20000
= -29184 + 20000
= Rs -9184
Scenario analysis indicates, there is risk for pessimistic estimate.

Example:
From the following information, calculate NPW for each scenario by assuming
I = 1, 25,000, MARR = 15% and life of project is 5 years.
Variable considered Worse-case Most Likely case Best-case scenario
Scenario
Unit demand /Yr 16,00 2,000 2,400
Unit price(Rs) 48 50 53
Variable cost(Rs)/unit 17 15 12
Fixed cost (Rs)/ unit 11,000 10,000 8,000
Salvage value ( Rs) 30,000 40,000 50,000

Solution:
a) Worse case scenario;
NPW (15%) = -1, 25,000 + (1,600 *48 – 1,600 *17 -11,000) (P/A, 15%, 5) + 30,000(P/F, 15%, 5)
= - 1, 25, 000 + (76800 – 27200-11000) *3.3522 + 30, 000* 0.4972
= - 125000 + 129394.92 + 14916
= Rs. 19311(Profit)
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b) Most likely case scenario;

NPW (15%) = -1, 25,000 + (2,000 *50 – 2,000 *15 -10,000) (P/A, 15%, 5) + 40,000(P/F, 15%, 5)
= -1, 25,000 + (100000-30000-10000)*3.3532 + 40000 * 0.4972
= - 1, 25, 000 + 201192 + 19888
= Rs. 96080(Profit)
c) Best case scenario
NPW (15%) = -1, 25,000 + (2,400 *53 – 2,400 *12 -8,000) (P/A, 15%, 5) + 50,000(P/F, 15%, 5)
= -1, 25,000 + (127200- 28800-8000) * 3.3532 + 50000 * 0.4972
= - 1, 25,000 + 303129.28 + 24860
= Rs. 202989.28(Profit)
Scenario analysis indicates, there is no risk for investment.
 Decision Tree and Sequential Investment Decision:

e. Node: The probability that is estimated must sum to 1 for each set of outcomes (branches) that results
from decision.
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For the evaluation and selection of the alternative, the following information is necessary

 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.

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) = 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 Alternatives
node
D

a. Figure Decision node

Outcomes
0.5
Probability node
0.2 Probabilities
0.3
b. Figure Probability node

D
D

Final outcomes

c. Figure Tree structure

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Example:

A business firm is considering to open its branch in either Bhaktapur or Lalitpur. From the preliminary
study, the following data has been obtained.

Bhaktapur Lalitpur
Probability Profit(Rs) Probability Profit(Rs)
Low Success 0.35 25000 0.28 18000
Medium Success 0.40 36000 0.38 29000
High Success 0.25 16000 0.34 23000

With the help of single line decision tree, which branch should the firm prefer?

Solution :

Profit Rs.
High 0.25 16000
Bhaktapur Medium 0.4
2 36000
Low 0.35 25000
1 High 0.34 23000
Lalitpur Medium 0.38 29000
3
Low 0.28 18000

From the decision tree diagram,

Expected return of Lalitpur
= 23000*0.34 + 29000 * 0.38 +18000 * 0.28
= Rs. 23880
Expected return of Bhaktapur
= 16000*0.25 + 36000 * 0.4 + 0.35 * 25000
= Rs. 27150
Since the expected return from Bhaktapur is greater than that of Lalitpur.
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Question 1.
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Question 2.
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