FLEXIBILITY IN DESIGN - Title Page - MIT

de Neufville + Scholtes D R A F T September 30, 2009[Tables 3.2 and 3.3 about here]Applying the standard discounted cash flow analysis to the case, we obtain the results inTable 3.3. As it shows, the project appears to be worthwhile, delivering positive NPV beyond therequired 10% cost of capital. Further, the 6-level design maximizes the NPV. In this case, asoften occurs, the design has a “sweet spot” that maximizes value. The graph of NPV versusnumber of levels illustrates this phenomenon (Figure 3.2). If the garage is too small, it does notgenerate enough revenue to cover the fixed costs. If it is too large, it may not fill up sufficiently tocover the costs of the large size. The right balance between being too small and too large liessomewhere in the middle.This analysis is standard and straightforward. The answers to the basic questions ofevaluation and design appear to be that the• Best design is to build 6 levels, and• Garage is a worthwhile opportunity and delivers an NPV of 2.5 million.Unfortunately, this solution is wrong on both counts. The next sections explain why theseanswers are incorrect.[Figure 3.2 about here]Recognizing effects of uncertaintyRecognizing the uncertainty: The actual evolution of demand for parking will be highly uncertainover the 15-year life of the project. Both the initial and the additional demand over the comingdecade and beyond could be much lower than expected – or they could be much higher.Alternatively, there could be low initial demand and high growth or vice versa. The value of theproject under any of these circumstances would not be the same as that based on the singleprojected estimate. In general, as indicated in the discussion of the flaw of averages, we cananticipate that the actual expected value of the project will be quite different from that calculatedin the naïve case that assumes just one possible outcome.Furthermore, as the example shows, the design that maximizes value can also bedifferent when we look at the realistic situation that acknowledges uncertainty. Such a change inthe optimal design may or may not occur. It is however a distinct possibility. As the exampleindicates, we cannot assume that the ranking of the alternative designs will be the same when weconsider uncertainty.To explore the effects of uncertainty in our simple example, we assume that the threeparameters defining demand can be off by up to 50% either side:• Initial demand can be anywhere between 375 and 1125 spaces;• Demand growth to year 10 can be anywhere between 375 and 1125 spaces; and• Demand growth after year 10 can be anywhere between 125 and 375 spaces.Part 1: Chapters 1 to 3 Page 47 of 69