Reference no: EM132242885

Assigned problem:  This is a typical decision analysis problem used in capital replacement situations. Take advantage of the ANALYTIC SOLVER to facilitate sensitivity analysis.

Delta Electric Services is an electrical-utility company serving parts of several states.  It is considering replacing some of its equipment at generating stations and is trying to decide whether to replace an older, existing PCB transformer. Although the PCB transformer meets all current regulations if an incident such as a fire would occur, and PCB contamination caused harm to neighboring businesses or farms, or to the environment, the company would be liable for damages.  Recent court cases have shown that simply meeting regulations does not relieve the company of liabilities if an accident causes harm to others.  In addition, courts have been awarding very large damages to individuals and businesses harmed by incidents involving hazardous materials such as PCBs.  

If Delta replaces the PCB transformer, no PCB incidents will occur, and the only cost will be the cost of the new transformer, estimated to be $85.000. Alternatively, if the company elects to keep the existing PCB transformer in operation, then, according to their consultants, there is a 50/50 chance that there will be in a high likelihood of an incident or a low likelihood of an incident. For the case of a high likelihood of an incident, there is also a 0.004 probability that a fire will occur sometime during the remaining life of the transformer, and a 0.996 probability that no fire will occur. If a fire occurs, there is a 20 percent chance that it will be severe and the utility will incur a very high cost, whereas there is an 80 percent chance that it will be minor and the utility will incur a low cost.

The high and low-cost amounts, including both cleanup and damages, are estimated to be $100 million and $10 million, respectively, based on results from other incidents in the industry. For the case of a low likelihood of an incident, there is a 0.001 probability of a fire during the remaining life of the transformer, and a 0.999 probability of no fire. If a fire does occur, the same probabilities exist for the severe and minor outcomes as in the previous case. In both cases, there will be no cost if no fire occurs.

Prepare a managerial report with your recommendations to Delta.

In the analysis, consider at least:

1. The expected cost of replacement versus no replacement

2. If Delta decides to replace the transformer, what would be your recommendation for the optimal negotiated price of transformers?

3. Perform a sensitivity analysis of the decision model when the low likelihood of an incident is revised from 0.001 to 0.01 assuming the same probabilities exist for the severe and minor outcomes as in the previous case.