ENME619.

12 Fundamentals of Pipeline Economics

TOPIC 9 RISK AND LOANS

Textbook:
• Riggs, J.L., Bedworth, D.D., Randhawa, S.U., and Khan, A.M., Engineering
Economics, 2nd Canadian Edition, McGraw Hill, 1997, Chapter 13.
Supplementary Readings:
• Blank, L., and Tarquin, A., Engineering Economy, 6th Edition, McGraw Hill, 2005,
Chapter 19.
• Park, C.S., Pelot, R., Porteous, K.C., and Zuo, M.J., Contemporary Engineering
Economics, 2nd Canadian Edition, Addison Wesley Longman, 2001, Chapter 13.
• Steiner, H.M., Engineering Economic Principles, 2nd Edition, McGraw Hill, 1996,
Chapters 12, 13.

9.1 Risk
9.1.1 Review of statistic mathematics
a. Probability Measurement
events
 Measured by experiments (or events out of trials): p( E )  lim
trials
Case 1: A pair of dice is believed to be unfair, that is, “loaded.” To determine the
probability of each number from 2 to 12 appearing on a given throw (or trial), the
dice are thrown a great many times. The appearance of 2 (out of 12), i.e. event, is
210 times out of 7200 throws (or trials). What is the probability of this event?
Solution:
210
p(2)   0.02917
7200

a
 Measured by mechanics of the system: p( E )  ; a: event happens; b event cannot
ab
happen.
Case 2: A gambler wishes to determine the probability of drawing the Queen of spades from
a standard deck of 52 cards. What is the probability for him to draw the Queen?
Solution:
1
p(Queen of spades )   0.01923
1  51

b. Expected Values
n
   E ( X )   pi X i
i 1
Case 3: What is the expected value of an unlimited number of tosses of the die?
Solution:
1 1 1 1 1 1
E ( X)  (1)  (2)  (3)  (4)  (5)  (6)  3.5
6 6 6 6 6 6

c. Summary
 p( E )  0

Paul Tu 9.1
 ENME619.12 Fundamentals of Pipeline Economics

 p( E1 U E2 )  p( E1 )  p( E2 )
 p( E1  E2 )  p( E1 )  p( E2 )
Case 4: Toss a pair of standard dice in unlimited times. What are probabilities for the sum of
numbers are 2, 3, 4, 5,…, 12?
Solution:
p(2)=(1/6)(1/6)=1/36
p(3)=(1/36)+(1/36)=2/36
Sum P Sum P Sum P Sum P
2 1/36 5 4/36 8 5/36 11 2/36
3 2/36 6 5/36 9 4/36 12 1/36
4 3/36 7 6/36 10 3/36

9.1.2 Uncertain Project Evaluation under Same Risk

a. Basic concepts
 Certainty: events have only unique solutions or outcomes.
 Uncertain projects may have multi-outcomes with occurrence probabilities
associated with each outcome.

b. Cases
Case 5: A telephone company, in a western state, with many miles of rural lines made a
study of telephone pole mortality. The results are condensed in the following table.
Age (years) 5 10 15 20 25 30 35 40 45
Percentage retired (%) 3 10 17 22 20 16 7 4 1 100%
A telephone pole costs $423.10 (including installation cost) according to the
accounting department. The cost of capital, before taxes, was 15%. What is the
expected annual cost of a telephone pole?
Solution:
n n
E ( A)   pi X i  423.10 p( A / P,15%, i)
i 1 i 1
=423.10[0.03(A/P,15%,5)+0.10(A/P,15%,10)+…+0.01(A/P,15%,45)]
=$70.45

Case 6: A large publicly owned metropolitan bus system has accumulated data on two
models of buses it has used over the past 5 years. Both models have exhibited frame
defects that have to repair at an average of $1,077 per failure. The following statistic
data on frame repairs are collected.
Year Model 1 Model 2 Model 1 Model 2
1 16 5 First cost $107,000 $111,000
2 35 11 Salvage value $10,000 $12,000
3 64 22 Maintenance cost (annual) $600 $600
4 76 40
5 87 67
A 5-year study period is chosen. The opportunity cost of capital is 10%. No taxes or
inflation are to be considered. Benefits are the same no matter which model is
chosen. Now the company has 267 Model 1 buses and 102 Model 2 buses. A new

Paul Tu 9.2
 ENME619.12 Fundamentals of Pipeline Economics

fleet of 1000 buses is to be purchased. Which model should be chosen? Use present-
worth method.
Solution:
Year 1: Model 1: (16/267)(1000)(1077)=$64,539; Model 2: (5/102)(1000)(1077)=$52,794
Year Model 1 Model 2 Increment (2-1)
0 -107,000,000 -111,000,000 -4,000,000
1 -64,539 -52,794 +11,745
2 -141,180 -116,147 +25,033
3 -258,157 -232,294 +25,863
4 -306,562 -422,353 -115,791
5 -350,933 -707,441 -365,508
5 +10,000,000 +12,000,000 +2,000,000
NPV2-1= -$3 million, Model 1 should be chosen.

Case 7: Bethesda Aviation plans to introduce a new aircraft which will compete directly
with the Cessna 150. The following are three cash flows, with their associated
probabilities, considered by the firm’s management to possible during the first 5
years of production:
Year Cash flow 1 (p=0.5) Cash flow 2 (p=0.3) Cash flow 3 (p=0.2)
0 -$10 million -$10 million -$10 million
1 $2 million $3 million $4 million
2 $ 4 million $4 million $4 million
3 $6 million $5 million $4 million
4 $8 million $6 million $4 million
5 $10 million $7 million $4 million
The sums are in constant, after-tax, year 0 dollars. If the constant-dollar, after-tax
opportunity cost of capital for Bethesda Aviation is 6%, what is the expected value
of the NPV of the venture?
Solution:
NPV1=-10+2(P/F,6,1)+4(P/F,6,2)+6(P/F,6,3)+8(P/F,6,4)+10(P/F,6,5)=14.29
NPV2=-10+3(P/F,6,1)+4(P/F,6,2)+5(P/F,6,3)+6(P/F,6,4)+7(P/F,6,5)=10.57
NPV3=-10+4(P/A,6,5)=6.85
µ=(14.29)(0.5)+(10.57)(0.3)+(6.85)(0.2)=11.69

9.1.3 Risk Measurement

a. Basic concepts
0.5
n 
 Risk: is measured by standard deviation:   E( X i   ) or
2 2

   pi ( X i   ) 2 
 i 1 
 A variation form of standard deviation:  2  E( X i ) 2   2
 The bigger standard deviation, the higher risk.

b. Risk assessment in economic project evaluation

  2 > 1  2   1 : Choose alternative 2.
  2  1  2 >  1 : Depends on risk preference of decision maker.

Paul Tu 9.3
 ENME619.12 Fundamentals of Pipeline Economics

  2 > 1  1 >  2 : Choose alternative 2.

 1 >  2  1   2 : Depends on trade-off between µ and σ.

Case 8: Calculate standard deviation for Case 7.

Solution:
Alternative Xi µ Xi-µ pi (Xi-µ)2 pi(Xi-µ)2
1 14.29 11.69 2.60 0.5 6.76 3.38
2 10.57 11.69 -1.12 0.3 1.25 0.38
3 6.85 11.69 -4.84 0.2 23.43 4.69

3
  pi ( X i   ) 2  3.38  0.38  4.69  2.91
i 1

Case 9: In Case 8, if another proposal is presented, say Piper Comanche, with an expected
NPV of $12.72 million and a standard deviation of $6.72 million, which will we
choose? Assume the trade-off between µ and σ is: an increase of $1 of NPV must be
balanced by at most a 25¢increase in standard deviation.
Solution:
ΔNPV=12.72-11.69=1.03
 max  2.91  (1.03)  25%  3.17 < 6.72
The Piper Comanche is rejected.

c. Security market line (SML)

 Some evidence exists to suggest that most businesses consider the relation between
risk and return as linear, i.e.:
k
 cons tan t
E ( NPVk )  NPV f
NPVf is the risk free NPV, e.g. government securities.

Figure 9.1 A possible trade off between risk and expected value.

Case 10: A lead mining company in Africa attempted to evaluate its prospecting operations.
The following table shows possible outcomes from five mining categories. What is
the risk of this mining project?

Paul Tu 9.4
 ENME619.12 Fundamentals of Pipeline Economics

Mining categories p NPV (000,000) p(NPV)

No discovery 0.934 -0.5 -0.467
Discovery 1 0.050 5 0.250
Discovery 2 0.010 10 0.100
Discovery 3 0.005 20 0.100
Discovery 4 0.001 50 0.050
Total 1.000 0.033
Solution:
5
E ( X i ) 2   p i ( X i ) 2  (0.934)( 0.5) 2  (0.050)(5) 2  (0.010)(10) 2  (0.005)( 20) 2  (0.001)(50) 2
i 1
 6.983
  6.983  (0.033) 2  $2.642 million.
This project has a very high risk which is nearly 80 times of its mean ($0.033 million). It
may be rejected.

9.2 Loans
a. Basic concepts
 The amount of money which is borrowed is called the principal of a loan.
 The interest of a loan can be determined by IROR (internal rate of return).

Case 11: An automobile loan of $10,000 will be repaid in three equal instalments of $4,380
in next three years. What is the interest of this loan?
Solution:
4380(P/A,i*,3)=10,000, (P/A, i*, 3)=(10000)/4380=2.283, i*=15%.
The interest is 15%.

b. Loan selection criteria

 Among a number of possible loans, the selection of a possible (or the best) loan is
decided by economic evaluation rather than simply comparing the interest rates.

Case 12: Henry Higgins Company is going to select a loan of $1 million which will be paid
off in 15 years to finance its new moulding shop between the two mortgage plans: 1)
equal annual payments of principal and interest of $146,820 at 12% interest rate; 2) a
total payment of $7,137,900 at the end of the 15th year at 14% interest rate. If the
opportunity cost of capital of the company is 25%. Ignore tax and inflation effects,
which loan should be chosen?
Solution:
(1) By using present-worth method:
NPV1=1,000,000-146,820(P/A,25,15)
=1,000,000-146,820 (3.859)=$433,422
NPV2=1,000,000-7,137,900(P/F,25,15)
=1,000,000-7,137,900 (0.0352)=$748,746
Decision: To choose Plan 2.

(2) By annual worth method:

Paul Tu 9.5
 ENME619.12 Fundamentals of Pipeline Economics

AC1=$146,820
AC2=7,137,900(A/F,25,15)=7,137,900(0.00912)=$65,098
Decision: To choose Plan 2.

Case 13: Assume your capital opportunity cost is 12%.

a) Your wife’s new fur coat will cost $8,000. Two plans of loan are available: 1)
equal monthly payment of $258.14 for 36 months at 10% interest rate; 2) equal
monthly payment of $261.91 at 11% interest rate. Which plan should be chosen?
b) Now a business friend of you offers a loan of $8,000 and requires a payment of
$10,000 in the end of 3rd year. Should you take it?
Solution:
a) To choose Plan 1.
b) AC=10,000(A/F, 12%/12, 36)=10,000 (0.0232)=$232 per month.
To take your friend’s offer.

Case 14: A tenant offers you two rental plans for a 11-month lease: 1) She pays you $600
on the first day of each month; 2) She pays you a total sum of $6,000 at the first day
she moves into the house. If your target investment return is 9%, which offer will
you choose or decline both offers?
Solution:
By using present-worth method:
NPV1=600+600(P/A,9%/12,10)=600+600(9.600)=$6,300.
NPV2=$6000.
Take offer 1.

c. Unequal-term loans
Case 15: Two loans are offered to a prospective borrower. Both are for $100,000 at 10%
interest rate. However, the first loan proposal requires repayment at the end of 1
year. The second requires repayment at the end of 10 years. Do not consider income
tax, inflation and financial stress, which loan should the borrower choose if: a) her
target investment return is 10%; b) 12%; or c) 8%?
Solution:
By using present-worth method:
a) NPV=0, no difference between two loans
b) NPV1-2=-110,000(P/F,12,1)+259,370(P/F,12,10)=-$14,702
Choose the second loan.
c) NPV=-110,000(P/F,8,1)+259,370(P/F,8,10)=$18,290.
Choose the first loan.

Comment: Equal service lives do not work for loans.

Case 16: A loan of $100,000 will be paid by: 1) annually equal amount at 14% interest rate
for 30 years; 2) annually equal amount at 13% interest rate for 15 years. If your
MARR (minimum attractive rate of return) is 20%, which loan should you choose?
At which rate, your decision will be changed?
Solution:

Paul Tu 9.6
 ENME619.12 Fundamentals of Pipeline Economics

By using present-worth method at MARR=20%:

AC1=100,000(A/P,14,30)=$14,280 per year.
AC2=100,000(A/P,13,15)=$15,474 per year.
NPV1=100,000-14,280(P/A,20,30)=$28,900
NPV2=100,000-15,474(P/A,20,15)=$27,600
Choose Loan 1.

100,000-14,280(P/A,i*,30)=100,000-15,474(P/A,i*,15)
or -1,194(P/A,i*,15)+14,280(P/A,i*,15)(P/F,i*,15)=0
i*=18%
I (%) Loan 1 ($) Loan 2 ($) Loan 2 – Loan 1 ($)
0 -328,400 -132,100 196,300
5 -119,500 -60,600 58,900
10 -34,620 -17,700 16,920
13 -7,040 0 7,040
14 0 4,960 4,960
18 21,200 21,200 0
20 28,900 27,660 -1,240
25 42,950 40,280 -2,670

d. Inflation effects
 Inflation helps debtors and hurts lenders.
Case 17: Adolph Galland Company wishes to borrow $10,000 for 10 years. The bank offers
two loan repayment schedules: Plan 10, at 10% interest, requires a level payment of
$1,628 per year. Plan 11, at 11% interest, will be paid back by a single payment of
$28,394 at the end of 10 years. The company requires a return on constant dollars of
25 percent, and inflation is projected at 4 percent per year.
(a) Is the bank quoting the correct payments on the loan?
(b) If the loans are equal in risk of default and all other things are equal, which loan
should be chosen? Use the individual NPV method to make your choice.
Solution
(a) 10,000-1,628(P/A, i*, 10)=0, i*=10%
10,000-28,394(P/F,i*,10)=0, i*=11%
Bank’s quotes are correct.

(b) u=(1+i)(1+f)-1=(1.25)(1.04)-1=0.30=30%
NPV10=10,000-1,628(P/A,30,10)=$4,966
NPV11=10,000-28,394(P/F,30,10)=$7,941
Choose Plan 11.

Case 18: At 26% interest compounded annually, $100,000 is borrowed for 2 years. During
these 2 years, the inflation rate is projected to be 20% per year.
(a) What is the annual cost of the loan?
(b) What is the uniform annual cost of the loan in year 0 (or constant) dollars?
Solution
(a) A=100,000(A/P, 26%, 2)=100,000(0.70248)=$70,248

Paul Tu 9.7
 ENME619.12 Fundamentals of Pipeline Economics

u  f 0.26  0.20
(b) i   0.05  5%
1 f 1  0.20
A=100,000(A/P,5,2)=100,000(0.53780)=$53,780
Year 1: (70,248)/(1+0.20)=$58,540; Year 2: (70,248)/(1+0.20)2=$48,753
In fact, 58,540(P/F,5,1)+48,753(P/F,5,2)=53,780(P/A,5,2)

e. Collateral
 It is a term which describes the security for a loan. A common example of a loan
secured by collateral is the home mortgage. The loan cannot be used for any other
purpose than the purchase of a specific house.
Case 19: A small investor, Dorsey Pender, wishes to acquire a residential rental property,
hold it for 5 years, and then sell it. The property’s selling price is $130,000 with 10%
down payment required. His net profit each year, exclusive of mortgage payments,
he estimates at $9,000. At the end of 5 years, he believes he can sell the house for
$160,000. The bank will lend him $117,000 at 13% for 30 years with the property to
be bought acting as collateral. If his target investment return is 10%, should he make
the investment?
Solution
Mortgage: A=117,000(A/P,13%,30)=$15,609 per year.
Remaining loan at the end of year 5: R=15,609(P/A,13%,30-5)=114,414
NPV=-130,000(10%)-(15,609-9000)(P/A,10%,5)+(160,000-114,414)(P/F, 10%, 5)
=-13,000-6,609(3.791)+45,586(0.6209)=-$9,750
He should not make this investment.

Case 20: A pipeline project to be considered by two pipeline companies, Small Pipeline Ltd.
And Large Pipeline Ltd. The Small Pipeline Ltd. Needs a loan at 15% for 8 years
with equal annual payments to finance this project. The Large Pipeline Ltd. can
finance this project through internal funds. The pipeline project costs $120,000 in
total. Over 8 years, the annual maintenance and operation cost will start at $3,000
and rise to $5,100 with constant annual increase of $300. If the MARR for both
companies is 20%, calculate the present worth for both companies and explain the
results.
Solution
Mortgage: A=120,000(A/P,15%,8)=$26,742 per year.
Small Pipeline Ltd.:
PW=26,742(P/A,20%,8)+3,000(P/A,20%,8)+300(P/G,20%,8)
=26,742(3.837)+3,000(3.837)+300(9.8831)=$117,085
Large Pipeline Ltd.:
PW=120,000+3,000(P/A,20%,8)+300(P/G,20%,8)=$134,476
How do you explain the results? Is the Small Pipeline Ltd. can make the project cheaper
than the Large Pipeline Ltd. does?

9.3 Tutorial Questions

Problem 1
A drought that affected the corn crop of a Mexican area had a probability of annual
occurrence and resulting cost of lost crops as follows:

Paul Tu 9.8
 ENME619.12 Fundamentals of Pipeline Economics

p Crop loss ($000,000)

0.01 3000
0.05 1500
0.10 500
0.20 200

Irrigation works have been proposed which will reduce the drought damage
incurred, but at the first costs and annual operations costs shown below:
First cost ($000,000) 1000
Annual cost ($000,000) 10
Life (years) 50
Salvage value 0
If this plan is adopted, the probability of damage will be reduced to the following:
p Crop loss ($000,000)
0.005 3000
0.02 1500
0.03 500
0.04 200
If the public sector MSRR is 12% and no inflation effects are considered, should the
dam be built?

Problem 2
Investment in vacant land is usually risky. In an area of large growth near Austin,
Texas, a lot was for sale at $35,000. The payoffs and their probabilities were
estimated as follows:
Net gains after taxes ($) p
-10,000 0.02
-5,000 0.03
0 0.10
5,000 0.50
10,000 0.20
50,000 0.10
100,000 0.05
1.00

i) What is the expected value of the net gains after taxes?

ii) What is the standard deviation? Comment on the riskiness of the venture.

Problem 3
The local telephone company in central Florida is reviewing options for the design
and construction of microwave transmission towers. One option is certain to be
chosen. The towers must be designed to withstand hurricane wind velocities. The
construction costs for three mutually exclusive alternatives for the tower design are
shown in the table below, along with the results of historical data on wind velocities
in the region and their probabilities of occurrence.
Construction Wind velocity range

Paul Tu 9.9
 ENME619.12 Fundamentals of Pipeline Economics

Tower design cost $ (miles per hour) p

0-99 0.7
A 560,000 100-119 0.12
B 600,000 120-149 0.1
C 650,000 150-180 0.08
Each tower option will withstand the range of wind velocities opposite it in the table.
If the range of velocities is exceeded, however, the tower will fall. If a tower is
blown over, it must be replaced immediately at its original cost. Thus the towers will
remain in service, as originals or replacements, for the foreseeable future.
It may be assumed that only one storm of sufficient magnitude to cause wind
velocities in excess of 100 miles per hour will occur per hurricane season per year.
No wind velocity has ever been recorded at higher than 180 miles per hour. The
probabilities shown in the table measure the likelihood of hurricane winds reaching
the range of velocities in any one year.
The towers have an estimated life of 25 years. Yearly maintenance costs will be
the same for each tower option. The telephone company uses a 10% opportunity cost
of capital. Tax and inflation effects will be the same for any option and may be
ignored.
Which option should be chosen? Use the annual-cost method for your decision.

Problem 4
A Middle Eastern country has received the following payment schedules from a
private German industrial complex. The loan of $300 million will cover financing,
design studies, construction, and 5 beginning years of operation of a large river basin
development. The country must choose a repayment schedule if it describes to go
ahead with the project.
The development will take 4 years to construct, and no loan payment will be
required during those years. Plan A delays payment for the first 2 years. Plans B and
C require payment from year 5 through year 15.
Payment ($000,000)
Year Plan A Plan B Plan C
1 0 0 0
2 0 0 0
3 0 0 0
4 0 0 0
5 0 50.526 24.000
6 0 50.526 24.000
7 45.158 50.526 24.000
8 45.158 50.526 24.000
9 45.158 50.526 24.000
10 45.158 50.526 24.000
11 45.158 50.526 24.000
12 45.158 50.526 24.000
13 45.158 50.526 24.000
14 45.158 50.526 24.000
15 345.158 50.526 324.000

Paul Tu 9.10
 ENME619.12 Fundamentals of Pipeline Economics

If the country estimates its opportunity cost of capital at 15%, which plan should be
chosen?

Problem 5
C.F. Moreno Engineering Company, newly established by close friends of yours, is
in need of working capital. If you will lend them $26,785, they will pay you $1,740
per year at the end of each 5 years from the time you make the loan. In addition, they
will pay, at the end of the fifth year, lump sum which will represent your original
loan appreciated at 15%, compounded annually, for 5 years. You anticipate an
inflation rate of 4% per year over the next 5 years. In terms of constant year-0
dollars, what will be your rate of return, to the nearest whole percentage, if you
make the loan under the above conditions? Ignore income tax.

Problem 6
Perpetual Home Funding offers 30-year fixed-rate mortgage at 10% with 2.75% of
the amount of the mortgage to be paid at time 0. It also offers 15-year fixed-rate
mortgages at 9% with 2.25% the amount of the mortgage to be paid at time 0 (i.e.
2.25 points as called in US). A mortgage of $200,000 is envisaged, to be paid off
annually.
i) Do not consider inflation. Which plan will a home buyer prefer if her
opportunity cost of capital before taxes is 8% and no tax effects are
considered?
ii) If inflation averaging 4% annually over the next 30 years is estimated, her
constant-dollar opportunity cost of capital before taxes is 8%, and no tax
effects are taken into account, which plan should the home buyer choose?
All rates need to be rounded to the nearest whole percentage for calculations.

Answers to the tutorial questions

Problem 1: No, since expected annual savings = $127.0 million < AC=$130.42 million.
Problem 2: i) $14,150; ii) $24,187.
Problem 3: ACA=128,912, ACB=126,120, ACC=123,630.
Problem 4: PWA=228, PWB=265, PWC=191, Choose Plan C.
Problem 5: i=15.38%.
Problem 6: i) PW30=237,821, PW15=212,167, Select the 15 year mortgage.
ii) PW30= 28,269.3, PW15=30,256.7, Select 15 year mortgage.

Paul Tu 9.11