Engineering Economic Analysis

304 UNCERTAINTY IN FUTURE EVENTS

An assembly line is built after the engineering economic analysis has shown that the antici-

pated product demand will generate profits.A new motor, heat exchanger,or filtrationunit is

installed after analysis has shown that future cost savings will economicallyjustify current

costs. A new road.,school, or other public facility is built after analysis has shown that the

future demand and benefitsjustify the present cost to build. However,future performance

of the assembly line, motor, and so on is uncertain, and demand for the product or public

facility is more uncertain.

Engineering economic analysis is used to evaluate projects with long-term conse-

quences when the time value of money matters. Thus, it must concern itself with future

consequences;but describing the future accuratelyis not easy.In this chapter we considerthe

problem of evaluatingthe future. The easiest way to begin is to make a careful estimate. Then

we examine the possibility of predicting a range of possible outcomes. Finally, we consider

what happens whenthe probabilities of the variousoutcomes areknown or may be estimated.

We will show that the tools of probability are quite useful for economic decision making.

Estimates and Their Use in Economic Analysis 10 UNCERTAINTYIN FUTURE EVENTS

Economic analysis requires evaluating the future consequences of an alternative. In prac-

tically every chapter of this book, there are cash flow tables and diagrams that describe

precisely the costs and benefits for future years. We don't really believe that we can exactly

foretell a future cost or benefit. Instead, our goal is to select a single value representing the

bestestimate that can be made.

We recognize that estimated future consequences are not precise and that the actual

values will be somewhat different from our estimates. Even so,itis likely we have made

the tacit assumption that these estimatesarecorrect. We know estimates will not always

turn out to be correct; yet we treat them like facts once they areinthe economic analysis.

We do the analysis as though the values are exact. This can lead to trouble. If actual costs

and benefits are different from the estimates, an undesirable alternative may be selected.

This is because the variability of future consequences is concealed .by assuming that the

best estimates will actually occur. The problem is illustrated by Example 10-1.

Two alternatives are being considered. The best estimates for the various consequences are as

follows:

A B

Cost $1000 $2000

Net annual benefit $150 $250

Usefullife, in years 10 10

= End-of-useful-life~salvage value $100 ..$400

If interest is 3Y2%, which alternative has the better net present worth (NI>W)?

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