POSSIBLE INACCURACY OF

CHAPTER 10 CASH-FLOW ESTIMATES

DEALING WITH • How much source information is
available
UNCERTAINTY • How dependable is the source
information
• Uncertainty in capital investment
requirements is often reflected as a
contingency above actual cost of plant
and equipment

TYPE OF BUSINESS INVOLVED

RISK
• Risk and uncertainty are similar in that
RELATIVE TO HEALTH OF
they both present the problem of not ECONOMY
knowing what future conditions will be
• Risk offers estimates of probabilities for Some businesses will typically be
possible outcomes more at risk of declining with when
• Uncertainty does not provide estimates of there is a general decline in the
probabilities for possible outcomes economy -- when the economy has
• This book treats them as interchangeable gone into recession

FOUR MAJOR SOURCES OF

TYPE OF PHYSICAL PLANT AND
UNCERTAINTY
EQUIPMENT INVOLVED
1. Possible inaccuracy of cash-flow
estimates used in the study • Some types of structures and
2. Type of business relative to the future equipment have definite economic
health of the economy lives and market values – they may
be used in a multitude of settings.
3. Type of physical plant and equipment
involved • Other dwellings and equipment,
being made for very specific and
4. Length of study period
singular functions, may have little or
no resale value

1
 BREAKEVEN PROBLEM INVOLVING
LENGTH OF STUDY PERIOD TWO ALTERNATIVES
The longer the study period, the Most easily approached
greater the level of uncertainty of a mathematically by equating an
capital investment equivalent worth of the two
alternatives expressed as a function
of the factor of interest

BREAKEVEN ANALYSIS FOR

SENSITIVITY ANALYSIS ECONOMIC ACCEPTABILITY OF AN
• Sensitivity – The degree to which a ENGINEERING PROJECT
measure of merit (I.e., PW, IRR, Most easily approached by equating an
etc…) will change as a result of equivalent worth of the project to zero as a
changes in one or more of the function of the factor of concern
study factor values. Because of the potential difference in
Sensitivity Analysis Techniques project lives, care should be taken to
1. Breakeven Analysis determine whether the coterminated or the
2. Sensitivity Graph (spiderplot) repeatability assumption best fits the
situation
3. Combination of factors

BREAKEVEN ANALYSIS EXAMPLE APPLICATIONS OF

• Technique commonly used when an uncertain single
factor (EG: capacity utilization) determines the
BREAKEVEN ANALYSIS
selection of an alternative or acceptability of an
engineering project • Annual revenue and expenses
• For given alternative, if best estimate of actual • Rate of return
outcome of common factor is higher or lower than
the breakeven point, and assumed certain, the best • Market (or salvage) value
alternative becomes apparent
1. Indifference between alternatives (EWA = f1(y); EWB = f2(y)
EWA = EWB; f1(y) = f2(y) : Solve for y
• Equipment Life
2. Economic acceptability of engineering project
EWp = f(z) = 0
• Capacity utilization
The value of ‘z’ is the value at which we would be indifferent
between accepting or rejecting the project

2
 SENSITIVITY GRAPH REVELATIONS OF SPIDERPLOT
• Shows the sensitivity of the present worth to
(SPIDERPLOT) percent deviation changes in each factor’s best
estimate
An analysis tool applicable when the
• Other factors are assumed to remain at their best
breakeven analysis does not fit the estimate values
project situation • The relative degree of sensitivity of the present
Makes explicit the impact of worth to each factor is indicated by the slope of
the curves (the “steeper” the slope of a curve the
uncertainty in the estimates of each more sensitive the present worth is to the factor)
factor of concern on the economic • The intersection of each curve with the abscissa
measure of merit shows the percent change in each factor’s best
estimate at which the present worth is zero

EXAMPLE 4-10
Investigate PW over a range of + 40% REVELATIONS OF SPIDERPLOT
changes in estimates for
a. Capital investment In this example
b. Annual net cash flow • Present worth is insensitive to MV
c. Market value • Present worth is sensitive to I, A, and
d. Useful Life N
PW(10%) = -$11,500 + $3,000 (P / A, 10%, 6) + $1,000 (P / F,10%, 6) = $2,130

SENSITIVITY GRAPH (SPIDERPLOT) OF MEASURING SENSITIVITY BY A

FOUR FACTORS COMBINATION OF FACTORS
PW (10%) 1. Develop a sensitivity graph for the project
7000 a. For most sensitive factors, improve
6000
estimates and reduce range of uncertainty
5000 $2130
2. Use sensitivity graph to select most sensitive
project factors. Analyze combined effects of
4000
these factors on project’s economic measure of
3000 merit by:
2000
+%Deviation
a. Additional graphical technique for two most
-% Deviation
Changes in
1000 Changes in sensitive factors
Factor
Factor
0 Estimate b. Determine the impact of selected
Estimate - 40 -30 -20 -10 +10 +20 +30 +40
-1000 combinations of three or more factors --
-2000 scenarios
-3000

-4000

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PITFALLS OF RISK-ADJUSTED
MARR
• A widely used industrial practice for including
some consideration of uncertainty is to
increase the MARR
• Even though intent of risk-adjusted MARR is to
make more uncertain projects appear less
economically attractive, opposite may appear
to be true
• Cost-only projects are made to appear more
desirable as the interest rate is adjusted
upward to account for uncertainty

REDUCTION OF USEFUL LIFE

• By dropping from consideration those
revenues (savings) and expenses that
may occur after a reduced study period,
heavy emphasis is placed on rapid
recovery of capital in early years of a
project’s life
• This method is closely related to the
discounted payback technique and
suffers from most of the same
deficiencies