Evaluation of Flexibility for a Primary Residence Michael Pasqual ESD.71: Application Portfolio Fall 2009Michael Pasqual ESD.71 Application Portfolio 2 of 28Abstract In this paper, we apply real-options analysis to the design – specifically the selection and possible expansion - of a primary residence. A primary residence can be viewed as a system that delivers benefit by providing shelter, specifically bedrooms, to family members. Due to the uncertainty in the size of the family over time, the best system design is not so obvious. We face a challenge to build capacity (i.e.., bedrooms) to meet uncertain demand (i.e., parents and children who need a place to sleep). Three design concepts are considered: (1) a fixed Big House, (2) a flexible Small House, or (3) a flexible Condo. We analyze the alternatives using decision analysis, lattice analysis, and simulation. Results from all three methods reveal that the Small House concept yields the highest expect net-present-value, in addition to other criteria.Michael Pasqual ESD.71 Application Portfolio 3 of 28 Table of Contents INTRODUCTION........................................................................................................................................ 5 SYSTEM DEFINITION................................................................................................................................... 5 MODEL ....................................................................................................................................................... 5 DISCOUNT RATE......................................................................................................................................... 6 PRINCIPAL UNCERTAINTIES................................................................................................................ 7 FAMILY SIZE............................................................................................................................................... 7 Data ...................................................................................................................................................... 7 Model.................................................................................................................................................... 7 HOME PRICES ............................................................................................................................................. 8 Data ...................................................................................................................................................... 8 Model.................................................................................................................................................... 9 DESIGN CONCEPTS................................................................................................................................ 10 CASH FLOWS ............................................................................................................................................ 10 RATIONALE FOR FIXED DESIGN................................................................................................................ 11 DECISION ANALYSIS............................................................................................................................. 12 STAGE 2.................................................................................................................................................... 12 STAGE 1 (FOLDING BACK)........................................................................................................................ 16 EVALUATION, TARGET CURVES, MULTIPLE CRITERIA ............................................................................. 20 LATTICE ANALYSIS............................................................................................................................... 22 LATTICE DEVELOPMENT .......................................................................................................................... 22 DECISION ANALYSIS FROM LATTICE ........................................................................................................ 23 SIMULATION............................................................................................................................................ 26 EVALUATION, TARGET CURVES, MULTIPLE CRITERIA ............................................................................. 26 CONCLUSION........................................................................................................................................... 28Michael Pasqual ESD.71 Application Portfolio 4 of 28 List of Figures Figure 1: Binomial Distribution of Number of Children................................................... 8 Figure 2: History of Inflation-adjusted Home Prices......................................................... 9 Figure 3: E[NPV] for fixed designs of varying size ........................................................ 11 Figure 4: 2-Stage Decision Tree ...................................................................................... 12 Figure 5: Stage 2 of Big House Concept ......................................................................... 13 Figure 6: Stage 2 of Small House Concept...................................................................... 14 Figure 7: Stage 2 of Condo Concept................................................................................ 15 Figure 8: Fold-back for Big House Concept.................................................................... 17 Figure 9: Fold-back for Small House Concept................................................................ 18 Figure 10: Fold-back for Condo Concept........................................................................ 19 Figure 11: Decision Analysis – VARG Curves............................................................... 21 Figure 12: Simulation - VARG Curves ........................................................................... 27 List of Tables Table 1: Home Prices in Medford, MA area...................................................................... 8 Table 2: Cash Flow ($K) for each design concept........................................................... 10 Table 3: Decision Analysis – Multiple Criteria............................................................... 20 Table