Risk Analysis CE 828

Pooyan Aslani, Ph.D. Department of Civil Engineering Fall 2008

Syllabus
Grading
For purpose of grading, the performance of students enrolled in CE 828 will be assessed using the following scoring system: Class Participation 15% Homework* 45% Final Exam/ Project 40%

Homework Assignments
Homework problems will be assigned weekly and are due by the beginning of the class through drop box system in my poly. All homework must be done in Microsoft Excel. Late homework will be given no credit. Students are encouraged to discuss & work on homework problems with other classmates, but all problems must be completed by the student her/himself; no copying will be permitted.

Options for Extra Credit: Project

You may complete a project of your own design. Your objective is to apply one or more of the concepts in this course to a specific problem in your area of interest. The application should be to a fresh problem and it should represent your work. Do not simply summarize an application that is described in the literature The report should be double-spaced, and it should not exceed 10 pages in length, including figures and tables. The report should be concise and clear; the emphasis is on creativity and quality, not quantity. I have to confirm your project topic and the final report and presentation is due December 5, 2005

Examination
final exam is formally scheduled for the following date: Thursday 18/12/2008

Text and Reader/Notes

Required Textbooks for this course are following:
Making hard decisions Clemen, R. and Reilly, T. 2004 update. ISBN: ISBN 0-495-01508-3 Against the Gods, The Remarkable Story of Risk'' Peter L Bernstein ISBN: 9780471295631 Data analysis using Microsoft Excel Middleton, M. Third Edition. Published by Thompson. ISBN: 0534402933 `Fooled By Randomness, The Hidden Role of Chance in Life and in the Markets,' Nassim Nicholas Taleb, 2nd Ed., ISBN: 978-0812975215 ``The Black Swan: The Impact of the Highly Improbable,''Nassim Nicholas Taleb, ISBN: 9780812975215 Wall Street Journal. You can get a student discount.

Recommended Reading:

Topics to be covered

See the Syllabus

What about you?

Introduces yourself What area of Civil Engineering are you interested in? What year are you in? Full time or Part time? Who do you work for? Beside the fact that CE 828 is one of the mandatory courses what do you expect from the course to learn?

Thinking?!
Thinking is important to all of us in our daily life. Good thinking is; therefore not something that is forced upon us in school:
It is something that we all want to do, Wants other to do, To achieve our goals and theirs

This approach gives a special meaning to the term rationale.

Rational
Rational does not mean, here, a kind of thinking that denies motions and desires. It means, the kind of thinking we would all want to do, if we were aware of our own best interest, in order to achieve our goals.

Decision
A decision is a choice of action- of what to do or not to do. Decisions may attempt to satisfy the goals of others as well as the selfish goals of the decision maker. Decision depend on beliefs and goals, but we can think about beliefs and goals separately, without even knowing what decisions they will affect.

What is Risk?
A risk is an event that may possibly occur, and if it did occur would have a negative impact on the goals of the organisation. Thus a risk is composed of three elements:
1. The scenario, 2. Its probability of occurrence, 3. The size of its impact if it did occur (either a fixed value or a distribution).

The concept of risk is about our recognition of future uncertainty. Risk implies that a given action has more than one possible outcome.

What is opportunity?
An opportunity is an event that may possibly occur, and if it did occur would have a positive impact on the goals of the organisation. Thus an opportunity is composed of the same three elements as a risk.

Characteristics of Risk
Risk is either subjective or objective.

Flipping a coin is an objective because the odds are well known. An objective risk can be described precisely based on theory, experiment, or common sense. Describing the odds for rain next Thursday is not so clear cut, and represent a subjective risk.

Subjective Risk
Given the same information, theory, computers, etc., weatherman A may think odds of rain are 30% while weatherman B may think the odds are 65% and neither are wrong! Describing a subjective risk is openended in the sense that you could always refine your assessment with new information, further study, or by giving weight to the opinion of others.

Characteristics of Risk
Deciding that something is risky requires personal judgment, even for objective risks.
Flipping a coin where you win $ 1 for head and loose $1 for tail would not be significant to most people. If the stakes were $100,000 and $100,000 respectively, most people would find the situation to be quite risky!

Characteristics of Risk
Risky actions and therefore risk are things that we often can choose or avoid. Individuals differ in the amount of risk they willingly accept.

The Need for Risk Analysis In Civil Engineering

Construction
Will the cost construction materials and labor be as forecast? Will a labor strike affect the construction schedule?

Structural
Will the level of stress placed on the structure by peak load crowds and nature be as forecast? Will the structure ever be stressed to the point of failure?

Assessing and Quantifying Risk

Recognizing a need for risk analysis. How do you quantify the risk you have identified for a given uncertain situation?

Quantifying Risk
Means determining all possible values a risky variable could take and determining the relative likelihood of each value.
Suppose your uncertain situation is the outcome from the flip of a coin. You could repeat the flip a large number of times until you had established the fact that half of the times it comes up tails and half of the times heads.

Describing Risk
Summarize the risk using a probability distribution. A probability distribution is a device for presenting the quantified risk for a variable.

What is Risk Analysis?

Risk analysis is any method qualitative and/or quantitative for assessing the impact of risk on decision situations.

WHAT IS ECONOMICS ?
The study of how limited resources is used to satisfy unlimited human wants. The study of how individuals and societies choose to use scarce resources that nature and previous generations have provided.

Resources

Land Labor Capital

Land
All gifts of nature, such as: water, air, minerals, sunshine, plant and tree growth, as well as the land itself which is applied to the production process.

Labor
The efforts, skills, and knowledge of people which are applied to the production process.

Capital
Real Capital (Physical Capital )
Tools, buildings, machinery -- things which have been produced which are used in further production

Financial Capital
Assets and money which are used in the production process

Human Capital
Education and training applied to labor in the production process

Origins of Engineering Economy

The perspective that ultimate economy is a concern to the engineer and the availability of sound techniques to address this concern differentiate this aspect of modern engineering practice from that of the past.

Origins of Engineering Economy

Pioneer: Arthur M. Wellington, civil engineer latter part of nineteenth century; addressed role of economic analysis in engineering projects; area of interest: railroad building Followed by other contributions which emphasized techniques depending on financial and actuarial mathematics.

PRINCIPLES OF ENGINEERING ECONOMY

1. Develop the Alternatives; 2. Focus on the Differences; 3. Use a Consistent Viewpoint; 4. Use a Common Unit of Measure; 5. Consider All Relevant Criteria; 6. Make Uncertainty Explicit; 7. Revisit Your Decisions

DEVELOP THE ALTERNATIVES

The final choice (decision) is among alternatives. The alternatives need to be identified and then defined for subsequent analysis.

USE A CONSISTENT VIEWPOINT The prospective outcomes of the alternatives, economic and other, should be consistently developed from a defined viewpoint (perspective).

USE A COMMON UNIT OF MEASURE Using a common unit of measurement to enumerate as many of the prospective outcomes as possible will make easier the analysis and comparison of alternatives.

CONSIDER ALL RELEVANT CRITERIA Selection of a preferred alternative (decision making) requires the use of a criterion (or several criteria). The decision process should consider the outcomes enumerated in the monetary unit and those expressed in some other unit of measurement or made explicit in a descriptive manner.

MAKE UNCERTAINTY EXPLICIT Uncertainty is inherent in projecting (or estimating) the future outcomes of the alternatives and should be recognized in their analysis and comparison.

REVISIT YOUR DECISIONS Improved decision making results from an adaptive process; to the extent practicable, the initial projected outcomes of the selected alternative should be subsequently compared with actual results achieved.

ENGINEERING ECONOMY AND THE DESIGN PROCESS An engineering economy study is accomplished using a structured procedure and mathematical modeling techniques. The economic results are then used in a decision situation that involves two or more alternatives and normally includes other engineering knowledge and input.

ENGINEERING ECONOMIC ANALYSIS PROCEDURE

1. Problem recognition, formulation, and evaluation. 2. Development of the feasible alternatives. 3. Development of the cash flows for each alternative. 4. Selection of a criterion ( or criteria). 5. Analysis and comparison of the alternatives. 6. Selection of the preferred alternative. 7. Performance monitoring and postevaluation results.

LIFE-CYCLE COST
Life-cycle cost is the summation of all costs, both recurring and nonrecurring, related to a product, structure, system, or service during its life span. Life cycle begins with the identification of the economic need or want ( the requirement ) and ends with the retirement and disposal activities.

FIXED, VARIABLE, AND INCREMENTAL COSTS

Fixed costs are those unaffected by changes in activity level over a feasible range of operations for the capacity or capability available. Typical fixed costs include insurance and taxes on facilities, general management and administrative salaries, license fees, and interest costs on borrowed capital. When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected.

RECURRING AND NONRECURRING COSTS Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis. Variable costs are recurring costs because they repeat with each unit of output . A fixed cost that is paid on a repeatable basis is also a recurring cost: $ Office space rental

DIRECT, INDIRECT AND OVERHEAD COSTS Direct costs can be reasonably measured and allocated to a specific output or work activity -- labor and material directly allocated with a product, service or construction activity; Indirect costs are difficult to allocate to a specific output or activity -- costs of common tools, general supplies, and equipment maintenance ;

DIRECT, INDIRECT AND OVERHEAD COSTS Overhead consists of plant operating costs that are not direct labor or material costs
indirect costs, overhead and burden are the same;

Prime Cost is a common method of allocating overhead costs among products, services and activities in proportion the sum of direct labor and materials cost ;

INTEREST & INTEREST RATE

The fee that a borrower pays to a lender for the use of his or her money. The percentage of money being borrowed that is paid to the lender on some time basis.

SIMPLE INTEREST
The total interest earned or charged is linearly proportional to the initial amount of the loan (principal), the interest rate and the number of interest periods for which the principal is committed. When applied, total interest I may be found by I = ( P ) ( N ) ( i ), where
P = principal amount lent or borrowed N = number of interest periods ( e.g., years ) i = interest rate per interest period

COMPOUND INTEREST

Whenever the interest charge for any interest period is based on the remaining principal amount plus any accumulated interest charges up to the beginning of that period.
Period Amount Owed Interest Amount Amount Owed Beginning of for Period at end of period ( @ 10% ) period 1 $1,000 $100 $1,100 2 $1,100 $110 $1,210 3 $1,210 $121 $1,331

ECONOMIC EQUIVALENCE
Established when we are indifferent between a future payment, or a series of future payments, and a present sum of money . Considers the comparison of alternative options, or proposals, by reducing them to an equivalent basis, depending on: interest rate; amounts of money involved; timing of the affected monetary receipts and/or expenditures; manner in which the interest , or profit on invested capital is paid and the initial capital is recovered.

ECONOMIC EQUIVALENCE FOR FOUR REPAYMENT PLANS OF AN $8,000 LOAN Plan #1: $2,000 of loan principal plus 10% of BOY principal paid at the end of year; interest paid at the end of each year is reduced by $200 (i.e., 10% of remaining principal) Year Amount Owed Interest Accrued Total Principal Total end at beginning for Year Money Payment of Year of Year owed at Payment ( BOY ) end of Year 1 $8,000 $800 $8,800 $2,000 $2,800 2 $6,000 $600 $6,600 $2,000 $2,600 3 $4,000 $400 $4,400 $2,000 $2,400 4 $2,000 $200 $2,200 $2,000 $2,200 Total interest paid ($2,000) is 10% of total dollar-years ($20,000)

ECONOMIC EQUIVALENCE FOR FOUR REPAYMENT PLANS OF AN $8,000 LOAN

Plan #2: $0 of loan principal paid until end of fourth year; $800 interest paid at the end of each year
Year Amount Owed Interest Accrued Total Principal Total end at beginning for Year Money Payment of Year of Year owed at Payment ( BOY ) end of Year 1 $8,000 $800 $8,800 $0 $800 2 $8,000 $800 $8,800 $0 $800 3 $8,000 $800 $8,800 $0 $800 4 $8,000 $800 $8,800 $8,000 $8,800 Total interest paid ($3,200) is 10% of total dollar-years ($32,000)

ECONOMIC EQUIVALENCE FOR FOUR REPAYMENT PLANS OF AN $8,000 LOAN

Plan #3: $2,524 paid at the end of each year; interest paid at the end of each year is 10% of amount owed at the beginning of the year.
Year Amount Owed Interest Accrued Total Principal Total end at beginning for Year Money Payment of Year of Year owed at Payment ( BOY ) end of Year 1 $8,000 $800 $8,800 $1,724 $2,524 2 $6,276 $628 $6,904 $1,896 $2,524 3 $4,380 $438 $4,818 $2,086 $2,524 4 $2,294 $230 $2,524 $2,294 $2,524 Total interest paid ($2,096) is 10% of total dollar-years ($20,950)

ECONOMIC EQUIVALENCE FOR FOUR REPAYMENT PLANS OF AN $8,000 LOAN

Plan #4: No interest and no principal paid for first three years. At the end of the fourth year, the original principal plus accumulated (compounded) interest is paid. Year Amount Owed Interest Accrued Total Principal Total end at beginning for Year Money Payment of Year of Year owed at Payment ( BOY ) end of Year 1 $8,000 $800 $8,800 $0 $0 2 $8,800 $880 $9,680 $0 $0 3 $9,680 $968 $10,648 $0 $0 4 $10,648 $1,065 $11,713 $8,000 $11,713 Total interest paid ($3,713) is 10% of total dollar-years ($37,128)

CASH FLOW DIAGRAMS / TABLE NOTATION

i = effective interest rate per interest period N = number of compounding periods (e.g., years) P = present sum of money; the equivalent value of one or more cash flows at the present time reference point F = future sum of money; the equivalent value of one or more cash flows at a future time reference point A = end-of-period cash flows (or equivalent end-ofperiod values ) in a uniform series continuing for a specified number of periods, starting at the end of the first period and continuing through the last period G = uniform gradient amounts -- used if cash flows increase by a constant amount in each period

CASH FLOW DIAGRAM NOTATION 1 1 1 2 3 4 5=N

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval.

CASH FLOW DIAGRAM NOTATION 1

P =$8,000

1 2

5=N

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. Present expense (cash outflow) of $8,000 for lender.

CASH FLOW DIAGRAM NOTATION A = $2,524 3 1

P =$8,000

1 2

5=N

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. Present expense (cash outflow) of $8,000 for lender. Annual income (cash inflow) of $2,524 for lender.

2 3

CASH FLOW DIAGRAM NOTATION A = $2,524 3 1

P =$8,000

1 2

3 4

5=N

i = 10% per year

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. Present expense (cash outflow) of $8,000 for lender. Annual income (cash inflow) of $2,524 for lender. Interest rate of loan.

2 3

CASH FLOW DIAGRAM NOTATION

A = $2,524

3 3 4 4

5 5=N

1
1
P =$8,000

1 2

i = 10% per year

2 3

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. Present expense (cash outflow) of $8,000 for lender. Annual income (cash inflow) of $2,524 for lender. Interest rate of loan.

Dashed-arrow line indicates amount to be determined.

RELATING PRESENT AND FUTURE EQUIVALENT VALUES OF SINGLE CASH FLOWS

Finding F when given P:

Finding future value when given present value

F = P ( 1+i ) N (1+i)N single payment compound amount factor functionally expressed as F = ( F / P, i%,N )
P 0 N=

F=?

RELATING PRESENT AND FUTURE EQUIVALENT VALUES OF SINGLE CASH FLOWS

Finding P when given F:

Finding present value when given future value

P = F [1 / (1 + i ) ] N
(1+i)-N single payment present worth factor functionally expressed as P = F ( P / F, i%, N )
0 P=? N= F

RELATING A UNIFORM SERIES (ORDINARY ANNUITY) TO PRESENT AND FUTURE EQUIVALENT VALUES

Finding F given A: Finding future equivalent income (inflow) value given a series of uniform equal Payments (1+i)N-1 F= A i uniform series compound amount factor in [ ] functionally expressed as F = A ( F / A,i%,N )

RELATING A UNIFORM SERIES (ORDINARY

ANNUITY) TO PRESENT AND FUTURE EQUIVALENT

VALUES

Finding F given A: Finding future equivalent income (inflow) value given a series of uniform equal Payments (1+i)N-1 F=A i uniform series compound amount factor in [ ] functionally expressed as F = A ( F / A,i%,N ) predetermined values are in column 4 of F=? Appendix C of text
1 2 3 4 5 6 7 8 A=

RELATING A UNIFORM SERIES (DEFERRED ANNUITY) TO PRESENT / FUTURE EQUIVALENT VALUES

If an annuity is deferred j periods, where j < N And finding P given A for an ordinary annuity is expressed by: P = A ( P / A, i%,N ) This is expressed for a deferred annuity by: A ( P / A, i%,N - j ) at end of period j This is expressed for a deferred annuity by: A ( P / A, i%,N - j ) ( P / F, i%, j ) as of time 0 (time present)

NOMINAL AND EFFECTIVE INTEREST RATES

Nominal Interest Rate - r - For rates compounded more frequently than one year, the stated annual interest rate. Effective Interest Rate - i - For rates compounded more frequently than one year, the actual amount of interest paid. i = ( 1 + r / M )M - 1 = ( F / P, r / M, M ) -1 M - the number of compounding periods per year Annual Percentage Rate - APR - percentage rate per period times number of periods. APR = r x M

Effective Interest Rate

Ex: the nominal rate is 16%/year compounded quarterly. What is effective rate? r= 16%/year divided by 4= 4%quarter. On an annual basis, this equals 16.99%/year. The general formula is ieff= (1+ r/M)M 1 ieff = (1+ 0.16/4)4 1= (1.04)4 1= 1.1699-1= .01699= 16.99%

Effective Interest Rate

A credit company advertises a nominal rate of 16% on unpaid balances compounded daily. What is the effective interest rate per year being charged? r = 16%/year, M= 365 days/ year ieff= (1+0.16/365)365-1=0.1735=17.35%

Effective Interest Rate

In the beginning of this section, I was defined simply as the interest rate per interest period. A more precise definition, we know, is that I is the effective interest rate per period. When compounding is continuous, we have special case in which ieff = er-1

PRESENT WORTH METHOD ( PW )

Based on concept of equivalent worth of all cash flows relative to the present as a base All cash inflows and outflows discounted to present at interest -- generally MARR PW is a measure of how much money can be afforded for investment in excess of cost PW is positive if dollar amount received for investment exceeds minimum required by investors

FINDING PRESENT WORTH

Discount future amounts to the present by using the interest rate over the appropriate study period PW = P Fk ( 1 + i ) k
k=0 N

i = effective interest rate, or MARR per compounding period k = index for each compounding period Fk = future cash flow at the end of period k N = number of compounding periods in study period interest rate is assumed constant through project The higher the interest rate and further into future a cash flow occurs, the lower its PW

Discount Rate
Three main factors must be considered:
Investment opportunities: what alternative opportunities are available for investment? Risk: is the proposed project more or less risky than the other options? Inflation: how much will inflation reduce the future purchasing power of our money?

Discount Rate
It is possible to think of the discount rate as being made up of three components related to these three factors:
The rate-of-return for risk-free investments, such as bank accounts or government bonds (i%) A risk premium that reflects the amount of risk in the project (r%) A premium to offset the expected effects of inflation (inf%)

DEPRECIATION
Decrease in value of physical properties with passage of time and use Accounting concept establishing annual deduction against before-tax income - to reflect effect of time and use on assets
value in firms financial statements

- to match yearly fraction of value used by

asset in production of income over assets economic life

PROPERTY IS DEPRECIABLE IF IT MUST : be used in business or held to produce income have a determinable useful life which is longer than one year wear out, decay, get used up, become obsolete, or lose value from natural causes not be inventory, stock in trade, or investment property

DEPRECIATION CONCEPTS
Adjusted cost basis -- allowable adjustment (increase or decrease) to original cost basis, used to calculate depreciation and depletion deductions Basis, or cost basis -- also called unadjusted cost -- initial cost of acquiring an asset, plus sales tax, transportation, and normal costs of making asset serviceable

DEPRECIATION CONCEPTS
Market Value (MV) -- Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact -- approximates present value of what will be received through ownership of property, including time-value of money (or profit)

DEPRECIATION CONCEPTS
The following terms are used in the classical (historical) depreciation method equations: N = depreciable life of the asset in years B = cost basis, including allowable adjustments d k = annual depreciation deduction in year k (1< k <N) d k* = cumulative depreciation through year k BV k = book value at the end of year k BV N = book value at the end of the depreciable (useful) life SV N = salvage value at the end of year N R = the ratio of depreciation in any one year to the BV at the beginning of the year

STRAIGHT-LINE (SL) METHOD

Simplest depreciation method: Assumes constant amount is depreciated each year over depreciable (useful) life d k = ( B - SVN ) / N d k* = kdk for 1 < k < N BVk = B - d k* This method requires an estimate of the final SV ( also the final book value at the end of year N )

DECLINING BALANCE (DB) METHOD

Sometimes called constant percentage method or Matheson formula Assumed annual cost of depreciation is fixed percentage of BV at beginning of year R is constant R = 2 / N when 200% declining balance used R = 1.5 / N when 150% declining balance used d1=B(R) d k = B ( 1 - R ) k-1( R ) d k* = B [ 1 - (1 - R ) k ] BV k = B ( 1 - R ) k BV N = B ( 1 - R ) N Because declining balance method never reaches BV = 0, its permissible to switch from this to straightline method so assets SVN will be zero or other desired value

SUM-OF-THE-YEARS-DIGITS (SYD) METHOD

Book value at the end of year k 2(B - SVN) (B - SVN) BVk = B - ----------------- k + ----------k (k + 1 ) N N (N + 1)

The cumulative depreciation through the kth year d k* = B - BV k

Thursday 11th Preliminary Data Analysis 1. Read Against the Gods pp.139 2. Homework posted at my.poly