ENGG 401 X2ENGG 401 X2Fundamentals of Engineering ManagementFundamentals of Engineering Management

Spring 2008Spring 2008

Chapter 7:Chapter 7:

Uncertainty and Risk AnalysisUncertainty and Risk Analysis

Dave LudwickDave Ludwick

Dept. of Mechanical EngineeringDept. of Mechanical Engineering

University of AlbertaUniversity of Albertahttp://members.shaw.ca/dave_ludwick/

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20082

ENGG 401 X2 – Fundamentals of Engineering Management

Some Pitfalls in Investment AnalysisSome Pitfalls in Investment Analysis

• Can not handle “base business” capital replacement analysis well.– What does one take as the incremental income?

• The math is more sophisticated than the forecasts, which are often evolve under political influence and/or a judgment call from a senior person.

• The accuracy of the forecast is frequently orders of magnitude less than the accuracy of the analytical tools employed.– A deceptive confidence can ensue.– ROI analysis is best for relative investment tests with fixed outputs.

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20083

ENGG 401 X2 – Fundamentals of Engineering Management

Uncertainty and RiskUncertainty and Risk

• Consider that you can make an investment that you expect will cost $1 million and provide $200k in benefits annually for 10 years, which will give an internal rate of return of 15.1%.– If MARR < 15.1%, you will want to invest in that project.

• Now consider that there is some degree of uncertainty in the investment:– Optimistically, the project could cost only $900k and provide $220k

in annual benefits.– Pessimistically, the project could cost as $1.1 million and provide

only $180k in annual benefits.

• Now will you invest in the project?

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20084

ENGG 401 X2 – Fundamentals of Engineering Management

Risk and its MitigationRisk and its Mitigation

• There are three fundamental ways of dealing with risk.– Contingency:Contingency:

• Include an allowance to cover for what you don’t know. This is standard for engineering and construction contracts.

– Return:Return:• The higher the perceived risk, the higher the hurdle rate. For example,

what percent of output is pre-sold? If low, require a higher return.

– Mitigation:Mitigation:• Identify the risk you can’t accept, and develop a plan to buy your way

out of that risk.

• Most larger projects will have a combination of all three.

• Most small projects will rely on contingency alone.

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20085

ENGG 401 X2 – Fundamentals of Engineering Management

ContingencyContingency

• Contingency shrinks as project definition increases.

• Project “draws” from contingency, monitoring it is a major project control tool.

• Monte Carlo simulation is often used to determine what size contingency to use.– Often triggered by “class” of estimate, where estimates for major

equipment, minor equipment labour costs, etc. each have probabilities associated with them

– Suffers from “GIGO” – inputs are highly judgmental and final output is often adjusted to fit prior expectations.

• Quantification of contingency is an area of active research.

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20086

ENGG 401 X2 – Fundamentals of Engineering Management

ReturnReturn

• We automatically expect higher return for higher risk.

• Some firms quantify this and tie it to specific business targets.

• Failure rate increases with higher risk and rate of return.– Venture capital firms operate at the far end of the spectrum and

expect 40% returns and a high drop out rate.

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20087

ENGG 401 X2 – Fundamentals of Engineering Management

Identification and MitigationIdentification and Mitigation

• Key questions:– What are the risk elements.– Who can take these?– What is the price?

• Example: You are developing a project in a foreign country and being paid in the local currency. If in the US, Europe or Japan, forward sales mechanisms are easy. In some other country, however, currency hedging mechanisms are non-existent and a national government, World Bank or other aid body is the most likely acceptor of risk.

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20088

ENGG 401 X2 – Fundamentals of Engineering Management

Hedging as Mitigation StrategyHedging as Mitigation Strategy

• Hedging is a method of offsetting risk by trading in various financial instruments

• Hedging can be accomplished by trading in securities such as options or futures

• Hedging makes financial planning easier• Hedging is when you invest in a security that will track

opposite of the risk you are trying to mitigate

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 20089

ENGG 401 X2 – Fundamentals of Engineering Management

Risk Elements – EPC CompanyRisk Elements – EPC Company

RiskRisk MitigationMitigationPolitical CIDA, WB or ADB guarantee.

Bankruptcy Completion (performance) bond or guarantee by more credit worthy party.

Project Cancellation

Prepayment, funds in trust, guarantee.

Delayed Start

Make national government a guarantor in the event of change of regulation.

Foreign exchange

Own currency as basis, hedge or guarantee.

Foreign taxes

Make national government a guarantor in the event of change of regulation.

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 200810

ENGG 401 X2 – Fundamentals of Engineering Management

Risk Elements – EPC Company (2)Risk Elements – EPC Company (2)

RiskRisk MitigationMitigationContract International arbitrator or court, guarantee by

national government.

Natural Disaster

Insurance.

Loss During Transport

Insurance (loss of item or business interruption??).

Strike / Lockout

A project specific “no strike / no lockout” agreement.

Technical Flaw

Formalized review, period constructability reviews.

IP Infringement

External or internal review, third party supplier indemnification.

Dave Ludwick, Dept. of Mech. Eng.Ch 7 – Uncertainty and Risk Analysis

Summer 200811

ENGG 401 X2 – Fundamentals of Engineering Management

Risk Elements – Operating CompaniesRisk Elements – Operating Companies

RiskRisk MitigationMitigationFeedstock / Utilities Price

Long term contract, hedging, re-opener clause in all contracts, vertical integration.

Product Price Drop

Pre-sold long term contracts (ensure enforceability).

Change in Regulations

Review likelihood of affecting some vs. all, develop industry based lobby, understand life cycle.

Change in Taxation

Review likelihood of affecting some vs. all, develop industry based lobby.