# Question

An electric utility company is trying to decide whether to replace its PCB transformer in a generating station with a new and safer transformer. To evaluate this decision, the utility needs information about the likelihood of an incident, such as a fire, the cost of such an incident, and the cost of replacing the unit. Suppose that the total cost of replacement as a present value is $75,000.

If the transformer is replaced, there is virtually no chance of a fire. However, if the current transformer is retained, the probability of a fire is assessed to be 0.0025. If a fire occurs, the cleanup cost could be high ($80 million) or low ($20 million). The probability of a high cleanup cost, given that a fire occurs, is assessed at 0.2.

a. If the company uses EMV as its decision criterion, should it replace the transformer?

b. Perform a sensitivity analysis on the key parameters of the problem that are difficult to assess, namely, the probability of a fire, the probability of a high cleanup cost, and the high and low cleanup costs.

Does the optimal decision from part a remain optimal for a wide range of these parameters?

c. Do you believe EMV is the correct criterion to use in this type of problem involving environmental accidents?

If the transformer is replaced, there is virtually no chance of a fire. However, if the current transformer is retained, the probability of a fire is assessed to be 0.0025. If a fire occurs, the cleanup cost could be high ($80 million) or low ($20 million). The probability of a high cleanup cost, given that a fire occurs, is assessed at 0.2.

a. If the company uses EMV as its decision criterion, should it replace the transformer?

b. Perform a sensitivity analysis on the key parameters of the problem that are difficult to assess, namely, the probability of a fire, the probability of a high cleanup cost, and the high and low cleanup costs.

Does the optimal decision from part a remain optimal for a wide range of these parameters?

c. Do you believe EMV is the correct criterion to use in this type of problem involving environmental accidents?

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