ENGG 401 X2 Fundamentals of Engineering Management Spring 2008 Chapter 7: Uncertainty and Risk Analysis Dave Ludwick Dept. of Mechanical Engineering University of Alberta

Dave Ludwick, Dept. of Mech. Eng. Ch 7 – Uncertainty and Risk Analysis Summer ENGG 401 X2 – Fundamentals of Engineering Management Some 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 ENGG 401 X2 – Fundamentals of Engineering Management Uncertainty 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 ENGG 401 X2 – Fundamentals of Engineering Management Risk and its Mitigation There are three fundamental ways of dealing with risk. –Contingency: Include an allowance to cover for what you don’t know. This is standard for engineering and construction contracts. –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: 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 ENGG 401 X2 – Fundamentals of Engineering ManagementContingency 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 ENGG 401 X2 – Fundamentals of Engineering ManagementReturn 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 ENGG 401 X2 – Fundamentals of Engineering Management Identification 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 ENGG 401 X2 – Fundamentals of Engineering Management Hedging 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 ENGG 401 X2 – Fundamentals of Engineering Management Risk Elements – EPC Company RiskMitigation PoliticalCIDA, WB or ADB guarantee. BankruptcyCompletion (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 ENGG 401 X2 – Fundamentals of Engineering Management Risk Elements – EPC Company (2) RiskMitigation ContractInternational 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 ENGG 401 X2 – Fundamentals of Engineering Management Risk Elements – Operating Companies RiskMitigation Feedstock / 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.