ENEE/ENMG 672 Homework 5

(Ch 5 & 7: Sensitivity Analysis & Basic Probability)

Grade: 15+25+20+10+10+10+10 = 100 + 10 EC

Homework Questions:

Chapter 5

1) (15) Questions
a. (5) What is a sensitivity study? Why does one perform them?
Answer: The sensitivity study is a technique utilized to ascertain the impact of
independent variables values over the given dependent variable under some
assumptions as specified. It is used to perform a what – if analysis which can
help in decision making.

b. (5) What are the three types of variables on which one should perform
Sensitivity Studies?
Answer: The three types of variables on which one should perform Sensitivity
Studies are dependent variables, independent variables and controlled
variables.

c. (5) In what order should they be conducted? Why?

Answer:
Following is the order of analysis:
i. Variables as it is easiest to analyze
ii. Probabilities next as it is bit difficult to analyze here and only
important variables must be analyzed
iii. Weights as the next order which is after Variables or Probabilities. This
is best done with the variables as it effects utility value.

2) (25) Suppose one has $1000 to invest for 1 year. One can invest in a CD that will
make between 4% and 6% (expected value of 5%). One can invest in Stock. If one
invests in stock, one can expect the brokerage fee to be between $50 and $100
(expected value of $75). One can expect that the return on the stock will be between
-15% and +40% (expected value of +12.5%).
a. (3) Develop an “Input Variable Range Table” (see Table 5.1)
Answer: Table 5.1 is attached at the appendix for ready reference.
The Input Variable Range Table is as follows:
CD Stock
Base Base
Min Case Max Min Case Max
price 1000 1000
Interest
Rate 4% 5% 6%
Fees $50 $75 $100
Returns -15% 12.5% 40%

b. (3) What is the “Base” Net Investment Profit (NIP) for each investment?
Answer: the “Base” Net Investment Profit (NIP) for each investment is as
follows:
CD=5%*1000= $50
Stock =12.5%*1000= $125. But here the fee is 50 so NIP = 125-75 = $50

c. (3) Perform a 1-Sided Sensitivity study for the effect of each variable on
(Note there are two cases CD case and Stock Case)
Answer: the 1-sided Sensitivity study for the effect of each variable on CD
case & Stock Case is as follows:

CD Stock
Min Expected Max Min Expected Max
One way sensitivity
analysis
Fees 50 75 100
Profit 40 50 60 -150 125 400
Ui 40 50 60 -200 50 300
 d. (3) Develop a Tornado Diagram from this study.
Answer: Tornado Diagram from this study is given below:
Variable Range Table
Variable Range Utility(variable)
Upper Lower Upper
Variable Name Lower Bound Base/Expected Bound Bound Base/Expected Bound
CD 4 5 6 40 50 60
Stock 50 75 100 40 50 60

Layer Codes
1 1
2 2
 e. (3) For which variables does it make sense to model as an uncertain event?
Why?
Answer: it makes sense to model on CD as an uncertain event as there is no
loss for this variable case.

3) (20) Consider problem 2) above. Suppose you believe that the probability that the
market will go up is somewhere between 20% and 30% (expected value is 25%).
Assuming expected values for CD rate and brokerage fee,
a. (3) Develop a decision tree model for this.
Answer:
b. (4) What is the expectation value for the buy stock decision? How does it
compare to the CD decision option? Which decision option would you
recommend? Why?
Answer:
The expected value to buy stock is $50, it compares well as the corresponding
value for CD is also $50. But, still I would recommend to go for CD as there
are still chances that the market will go down.

c. (3) Perform a probability sensitivity analysis. How is your decision

recommendation affected by this result? Why?
Answer:

The probability sensitivity analysis is as follows:

Base Value
Case Profit EV

CD 0.75 37.5 787.5

Stock 0.25 31.25 281.25

Low q Case

CD 0.8 40 840
Stock 0.2 -30 170
 High q Case

CD 0.7 35 735
Stock 0.3 120 320

4) (Extra Credit 10) Clemen 1st & 2nd Edition: Read the “Facilities Investment and
Expansion Case Study”
a. (5) Question 1. (Ch. 5 pp. 213-214).
b. (5) Develop a Tornado Diagram for the top 10 variables.
c. (5) Explain your answer to Case Study Question 1. in terms of the Tornado
Diagram.

Or

Clemen 3rd Edition: Read the Strenlar Case Study (Ch. 4, pp. 171-172) and Strenlar
Part II (Ch. 5, pp. 229).
a. Create Tornado diagrams for each decision options using the variables
suggested to analyze the sensitivity.
Answer:
Below mentioned assumptions are taken. The Tornado diagram is represented
below:
Tornado Graph Data
Decision Tree 'Strenlar' (Expected Value of Entire Model)
Minimum Maximum
Output Input Output Input
Change Change
Rank Input Name Cell Value (%) Value Value (%) Value
1 Variable Costs (B14) B14 $1,636,00 -69.36% 0.8 $5,956,00 11.56% 0.6
0 0
2 Gross Sales (B5) B5 $1,773,14 -66.79% 2500000 $5,338,85 0.00% 4500000
3 0 7 0
3 Fixed Costs (B13) B13 $3,898,85 -26.97% 8000000 $6,778,85 26.97% 2000000
7 7
4 Prob of Winning Case (B4) B4 $4,355,71 -18.41% 0.5 $6,813,57 27.62% 0.75
4 1
5 Prob(Mfg Process Works) (B3) B3 $4,606,00 -13.73% 0.7 $6,071,71 13.73% 0.9
0 4
6 Legal Fees (B8) B8 $5,326,85 -0.22% 90000 $5,354,85 0.30% 20000
7 7
7 Interest Rate (B9) B9 $5,338,85 0.00% 0.05 $5,338,85 0.00% 0.05
7 7
8 PI Stock Price (B10) B10 $5,338,85 0.00% 48 $5,338,85 0.00% 48
7 7
 b. Based on your analysis, discuss your results and the implications for Fred’s
decision model. If he were to refine his model, what refinements should he
make?
Answer:
From the above model it is clear that Fred’s decision is sensitive to costs and it
is much more that the probability of winning the case, although it matters.
This is so as we can see from the tornado diagram. The refinements must be
focused on the costs and optimizations.

In order to do a good job with the analysis, a number of assumptions must be made.
Assume the following:
• $8 million in profits is the present value of all profits to be realized over time.
• $35 million in sales is also the present value of all future sales.
• Fred Wallace’s interest rate is 7.5% per year.
• Fred’s time frame is 10 years. We will use 10 years to evaluate the job offer and
the lump sum.
• If Fred goes to court, he continues to be liable for the $500,000 he owes. The $8
million in profits is net after repaying the $500,000. As indicated in the case, If
Fred and PI reach an agreement, then PI repays the debt.
• If Fred accepts the lump sum and options, and if the manufacturing process
works, then the options pay 70,000 × $12 at a point 18 months in the future. Thus,
the present value of the options is 12×70,000/1.03753= $752,168. That is, we
figure three periods at 3.75% per period. The purpose of this is simply to put a
value on the options.
• The options are non-transferable. Thus, there is no need to figure out the “market
value” of the options.

Chapter 7:

1) (10) Questions:
a. (6) Identify and briefly describe the three major types of Probability?
Answer: following are the 3 types of probabilities:
Analytic: it relates to the events /outcomes depending on pre-suppositions for
instance probability of rolling a 2 on “perfect die”.

Empiric: it relates to the events /outcomes depending on empirical data for

instance probability of rolling a 2 on “real die” after observations that it comes
10/ 100 trial.

Subjective: it relates to the events /outcomes depending on gut feeling on how

probable an event is, for instance probability of rolling a 2 on die given by
someone we do not know under conditions that we bet $500 that we will
succeed in rolling a number 2 at least once out in 20 consecutive trials.
 b. (2) Identify and briefly describe the two major types of Random Variable?
Answer:
The two major types of Random Variables: Discrete and Continuous. Discrete
Random Variables have finite possible values. The Continuous Random
Variables have infinite or uncountable values.

c. (2) Identify and briefly describe the two major types of probability
distributions?
Answer: the two major types of probability distributions are discrete and
continuous Probability Distributions. It is based on the respective probability
where in the discrete the distribution is on the set of finite probabilities and the
latter case is on the set of continuous or uncountable set of probabilities.

d. (5) How does the type of distribution determine how one calculates the mean
or variance of a distribution or data set? Provide equations.
Answer: the equations are as follows:
μ = EV(x) = Σ P(Xi) * Xi (discrete distribution)
μ = EV(x) = ∫ ρ(x) x dx (continuous distribution)

VAR(x) = Σ P(Xi) (Xi- μ)^2 (discrete distribution)

VAR(x) = ∫ ρ(x) (x - μ)^2 dx (continuous distribution)

1) (10) Do Problem 7.2 – Random Variable Explain in your own words what an
uncertain quantity or random variable is. Why is the idea of an uncertain quantity
important in decision analysis?

Answer: Random variable is one whose value is unknown or a function that assigns
values to an outcome is unknown. Most of the decision outcomes are unknown and
can assume any value. For example if we throw a dice we do not know what we will
get as outcome whether it will be 1 or 6. So we can have a random variable between 1
& 6 to get an outcome. Many decisions are also similarly unknown and therefore we
need the idea of an uncertain quantity in decision analysis.

2) (10) Do Problem 7.7 – EV, VAR, & SD

Answer: Calculate the variance and standard deviation of the returns of stocks AB,
CD, and EF in the portfolio example of this chapter. See Figure 7.8.

Calculate the variance and standard deviation of the returns of stocks AB, CD, and EF in
the portfolio example of this chapter. See Figure 7.8.
Figure 7.8
Answer:
For stock AB, E (Return of AB) = 0.15(-2%) + 0.50(5%) + 0.35(11%) = 6.1%. Similarly,
E (Return of CD) = 5.0%, and E (Return of EF) = 9.0%. These are needed to calculate the
variances and standard deviations.
Var (Return of AB) = 0.15(-2% - 6.1%)2 + 0.50(5% - 6.1%)2 + 0.35(11% - 6.1%)2
= 0.15(-0.02 – 0.061)2 + 0.50(0.05 – 0.061)2 + 0.35(0.11 – 0.061)2 = 0.0019
Thus, the standard deviation of the return on AB is √0.0019=0.043=4.3%.
Similarly, Var (Return of CD) = 0.0003 and the standard deviation of the return on CD is
1.8%. Also, Var (Return of EF) = 0.0243 and the standard deviation of the return on EF is
15.6%.

3) (10) Clemen 1st & 2nd Edition: Do Problem 7.16, Clemen 3rd Edition: Do Problem
7.15 (same problem) – EV, VAR, & SD

If P(X=1) =p and P(X=0) = 1-p, show that E(X) = p and Var(X) = p(1-p)

Answer:
We know that = E(x) = Σ P(Xi) * Xi
= P(X=0) * Xi + P(X=1) * Xi = p+0 =p
 E(x) =p
VAR(x) = Σ P(Xi) (Xi- μ)^2 = (X=0) * Xi + P(X=1) * Xi (1-p)
=p(1-p)

Some Other Potential Test Questions:

2) What is a Type III Error?

3) What is a Type I Error? A Type II Error?
4) What is a one-way sensitivity study?
5) What is a two-way sensitivity study?
6) What is a tornado diagram? What does it permit you to do?
7) How does one construct a tornado diagram?
8) Given the American Eagle Example done in class, perform a High/Low r analysis.
a. Determine the Base, High and Low r value EV for the purchase decision
b. Does the range in r or the range cause a greater variance in the EV for the
purchase decision? Explain.

9) What are the four Axioms of Probability Theory?

10) What are the four Fundamental Theorems?
11) What does it mean for two events to be independent?
12) What does it mean for two events to be mutually exclusive?
13) What is the difference between a Probability Mass Function (PMF) and a Probability
Density Function (PDF)?
14) Is a PDF a probability? Explain why or why not.
15) What is a Cumulative Distribution Function? How is it related to the PMF and PDF?
16) What is an “expectation value” of a distribution or data set?
17) What is a “Random Variable” (RV)?
18) How is the Variance of a RV related to the mean of the RV and the expectation value
of the square of the RV?
19) How does one calculate the standard deviation for a distribution or data set?
20) What does the mean tell you about a distribution/data set? What does the standard
deviation tell you?
21) What is the covariance of two variables? What does it measure?

Appendix:
Table 5.1
Astoria St. Barnard St. Charlotte St.

Price $450,000 $750,000 $600,000

Down Payment $45,000 $45,000 $15,000
Interest Rate 5.5% 7.0% 7.0%
l ax Rate 33% 33% 33%
Property Tax Rate 1% 1% 1%
Percentage Rented 0% 40% 35%
Costs

Mortgage (30 yr fixed) $27,866 $56,813 $47,143

Homeowner’s Insurance $1,080 SI,800 $1,440
Repair &: Upkeep $2,400 $3,200 $4,000
Property Taxes $4,500 $7,500 $6,000
Annual Cost $35,846 $69,313 $58,583
Rental
Monthly Rent $0 $2,000 $1,500
Months Occupied 0 10 10
Rental Income so $20,000 $15,000

Tax Deduction on Interest $7,173 S9,562 $8,595

Net Annual Cost $28,673 $39,752 $34,988