ESD.70J Engineering Economy Module

ESD.70J Engineering Economy Module - Session 4 1

ESD.70J Engineering Economy Module

Fall 2005Session Four

Alex Fadeev - [email protected]

Link for this PPT: http://ardent.mit.edu/real_options/ROcse_Excel_latest/ExcelSession4.pdf


Questions for “Big vs. small”

The past three sessions have covered ways to model uncertainty. It seems like the big plant is better… Does it feel right?

Note: we had assumed a commitment to building one small plant each year regardless of what demand reality turns out to be. So much for flexibility and common sense. Lets correct that oversight!


Outline

• Building flexibility into the model

• VAR chart

• Breakeven analysis - Goal Seek/Spinner

• Excel self-study references


A key inadequacy of traditional NPV analysis

• It assumes that future decisions are made today, for example for small plants construction

Decide whether to build a plant



Year 1 Year 2 Year 3

• But the decisions are actually made each year


Year 1 Year 2 Year 3


A key inadequacy of traditional NPV analysis (Cont)

• There is a LOT of value in delaying decisions until:– More information becomes available– Forecast uncertainty decreases with time and

additional data

• Ability to delay decisions into the future is flexibility

• Flexibility is the magic bullet against uncertainty


Modeling contingency decisions (flexibility) in spreadsheet

• Check the spreadsheet we built for Session Two (http://ardent.mit.edu/real_options/ROcse_Excel_latest/Session2-1.xls)

• Press “F9” and check which plan is better?• Think about the following decision rule:

– After the first plant is built in year 1, we build an additional small plant only if we observe a bigger demand than capacity

• How do we model that?


Modeling contingency decisions (flexibility) in spreadsheet (Cont)• In “Plan B” sheet, type

– “=IF(E5>E4,E3+1,E3)” in Cell G3, and– “=IF(G5>G4,G3+1,G3)” in Cell I3

• Press “F9”• Now which plan is better?• How easily can the traditional analysis be

misleading, despite properly simulate the uncertainties!


• Other decision rule to suggest?

• Let us think how to model this rules?


Functions can be used for modeling flexibility

• IF(logical_test,value_if_true,value_if_false): Returns one value if a condition you specify evaluates to TRUE and another value if it evaluates to FALSE.

• MAX(number1,number2,...): Returns the largest value in a set of values.– Often our decisions are to maximize among different

alternatives

• MIN(number1,number2, ...): Returns the smallest number in a set of values.

• etc.


Value at Risk (VAR) Chart• Value at Risk (VAR):

– A loss that will not be exceeded at some specified confidence level.

• The VAR chart is aimed at making a representation of– “We are X percent certain that we will not lose

more than Y dollars for this project.”

• VAR is a common language on Wall Street, It stresses downside risk, though we should also look at CDF for upside potential of a project


Draw VAR ChartFollow the instructions, step by step

1. Open our latest spreadsheet, add a new sheet, and name it “VAR”

2. Type “NPVA” in Cell A1, “Rank” in Cell B1, “NPVB” in Cell E1, “Rank” in Cell F1

3. Type “=Simulation!B8” in cell A2, drag down to A2001; Type” =Simulation!D8” in cell E2, drag down to E2001

4. Type “=RANK(A2,$A$2:$A$2001,1)” in cell B2, and drag down to B2001; Type “=RANK(E2,$E$2:$E$2001,1)” in cell F2, and drag down to F2001


6. Type “98%” in both cell J1 and J2

7. Type “=IF(B2=(1-$J$1)*2000,A2,0)” in cell C2, and drag down to C2001; type “=IF(F2=(1-$J$2)*2000,E2,0)” in cell G2, and drag down to G2001

8. Type “=IF(C2=0,0,1)” in cell D2, and drag down to D2001; type “=IF(G2=0,0,1)” in cell H2, and drag down to H2001

9. Type “VAR for NPVA is” in cell K1; type “VAR for NPVB is” in cell K2

10. Type “=SUM(C2:C2001)/SUM(D2:D2001)” in cell L1; type “=SUM(G2:G2001)/SUM(H2:H2001)” in cell L2


11. Copy the CDF chart from the “Simulation” sheet to “VAR” sheet

12. Type “=L1” in K5, type “=L1” in L5, type “1” in K6, and type “0” in L6

13. Type “=L2” in K8, type “=L2” in L8, type “1” in K9, and type “0” in L9

14. Type "=TEXT(J1,"?%")&" VAR for NPVA"" in M5, type "=TEXT(J2,"?%")&" VAR for NPVB"" in M8

15. Right click the CDF chart, click “Chart Options”, change “Chart title:” from “CDF” to “VAR”

16. Right click the VAR chart, click “Source Data”, click “Series”. • Click “NPVA Mean” in the left hand window, change “Name:” to “=VAR!

$M$5”, change “X Values:” to “=VAR!$K$5:$L$5”, change “Y Values:” to “=VAR!$K$6:$L$6”,

• Click “NPVB Mean” in the left hand window, change “Name:” to “=VAR!$M$8”, change “X Values:” to “=VAR!$K$8:$L$8”, change “Y Values:” to “=VAR!$K$9:$L$9”,

• click “OK”.


Explanation• RANK(number,ref,order): Returns the rank of a number

in a list of numbers. • Formulas in column C and G find out the value for the

rank corresponding to the specified confidence interval• Formulas in column D and H deal with the exception

event when rank ties– If the rank corresponding to the specified confidence interval

ties, it returns the correct result– If the rank corresponding to the specified confidence interval

is jumped by because of other ties, it returns error message


• Try different confidence intervals by changing values in J1 and J2…

• Compare 98% VAR value for – Plan A– Plan B without flexibility– Plan B with flexibility


Question for “Big vs. small”

Since Plan B with flexibility is better than Plan A, the manager are about to go with small plant. But the Chief Operations Officer reports the variable cost for the big plant can be further cut (the variable cost for a small plant remains the same). What is the maximum variable cost such that Plan A is still favored?


Breakeven analysis

• A breakeven level for a parameter – a target value of the parameter at which some particularly interesting event occurs

• In a deterministic case, a breakeven point can be determined by “Goal Seek”

• In a simulation case, we have to do trial-and-error search, “spinner” is a useful tool to help Excel trial-and-error


Goal seek

• Follow the instructions, step by step1. In sheet “Goal Seek”, type “='Plan A'!C16-'Plan B'!

C16” in cell C2

2. Click “Goal Seek” under “Tools” menu– Set cell: C2– To value: 0– By changing cell: Entries!$C$18– Click “OK”

• Check the value in cell C18 of “Entries” sheet

Open the deterministic model from http://ardent.mit.edu/real_options/ROcse_Excel_latest/Session4-2.xls


SpinnerFollow the instructions, step by step:1. In 1.xls, click “Worksheet” under “Insert” menu, name it “Spinner”2. Choose View -> Toolbar -> Forms3. Click the spinner button and draw a spinner from D3 to D44. Right click the establishes spinner, click “Format Control”5. Change “Current value:” to “128”, put “C4” in “Cell link:”6. Type “Variable cost for big plant” in cell B7, type “=C4/100” in B8,

type “NPVA – NPVB” in B9, type “=Simulation!$O$2-Simulation!$O$3” in B10

7. In “Entries” sheet, type “=Spinner!B8” in C188. Go to “Spinner” sheet, click spinner and press “F9” to find the

value such that NPVA – NPVB is 0


Excel self-study references

• MS Support center http://support.microsoft.com/?scid=ph;en-us;2512

• “Advanced Excel for Scientific Data Analysis” by Robert De Levie

• “Advanced modeling in finance using Excel and VBA” by Mary Jackson, Mike Staunton

• www.amazon.com


Big picture of Excel• Basics

– Names– References– Formula– Functions

• Charts• Sensitivity analysis• Statistical analysis• Optimization (Solver)• Simulation• Database

Database functionsDate and time functionsEngineering functionsFinancial functionsInformation functionsLogical functionsLookup and reference functionsMath and trigonometry functionsText functionsMacros

Advanced Excel manipulation: Visual Basic


Using Excel Help

• Ways to search – Contents– Answer wizard– Index– Online at http://support.microsoft.com– Google

• Explore links to related topics


Summary• Incorporating flexibility into the models• VAR Chart• Breakeven analysis

• Spreadsheet as the second best way to do many kinds of modeling… (after specialized $oftware).

• Arguably, it is the best tool for modeling, at least the initial pass. Like a Swiss Army knife, it will accompany you throughout your career.

• We hope this short course increases your awareness of some of Excel’s intermediate functionality

• Uncertainty management is cool !

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ESD.70J Engineering Economy Module