Decisions Under Uncertainty 6y5448

Uncertainty and Capital Budgeting ACCT 7320, 12/8/09, Bailey 

This presentation contains two parts: – A general model of decision-making under uncertainty, using “expected value” – Discussion of “Using Decision Trees to Manage Capital Budgeting Risk,” J. Bailes & J. Nielsen, Management ing Quarterly, Winter 2001

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Decision Models and Uncertainty Managers frequently must deal with uncertainty.  The model presented here represents a rational approach to decision making under uncertainty, assuming you are risk-neutral. 

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Decision Model Assumptions Choice Criterion  Set of Alternatives (Actions to consider) 

Mutually exclusive, Exhaustive

Set of Events (States of Nature)  Set of Probabilities associated with the events  Set of Outcomes (Income, cost, etc., to minimize or maximize) 

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Example of DM under Uncertainty

E v e n t 

Get Govt Contract Not get Govt Contract

Action Taken Buy new Eqpt Keep old Eqpt Income = Income = $500,000 $300,000 Income = $10,000

Income = $200,000

Which action is best? Depends on probabilities we assign to the events. 3-4

Decision Models and Uncertainty 

EV=Σ (Outcomei) (Pi)

i.e., summation of each outcome (in this case, income) times the probability of that outcome.

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Suppose P(getting contract) = .20

[read as “probability of getting contract = .20”]

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Thus P(not getting contract) = .80. EV(buying new Eqpt) = $500,000*.20 + $10,000*.80 = $108,000 EV(keeping old Eqpt) = $300,000*.20 + $200,000*.80 = $220,000

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To maximize expected value, we keep old equipment.

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Forest Product Companies and Timberland Long-term capital-budgeting decisions – More risk – Time value of money especially important  Typical decision: – Buy timberland now, or – Buy timber as needed 

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The basic decision Starting point in hypothetical case assumes indifference given the current regulatory environment, for simplicity only.

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Uncertainty: Regulatory environment may change

Management’s estimates.

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Possible Regulatory Environments and Related Outcomes

$6.57.0 $6-4.5 3-9

Expected Values of the Two Actions

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The End

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