Uncertainty and Capital Budgeting ACCT 7320, 12/8/09, Bailey Ø 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 Accounting Quarterly, Winter 2001 3 -1
Decision Models and Uncertainty Ø Managers frequently must deal with uncertainty. Ø The model presented here represents a rational approach to decision making under uncertainty, assuming you are risk-neutral. 3 -2
Decision Model Assumptions Ø Choice Criterion Ø Set of Alternatives (Actions to consider) Mutually exclusive, Exhaustive Ø Set of Events (States of Nature) Ø Set of Probabilities associated with the events Ø Set of Outcomes (Income, cost, etc. , to minimize or maximize) 3 -3
Example of DM under Uncertainty E v e n t Ø Get Govt Contract Not get Govt Contract Action Taken Buy new Eqpt Keep old Eqpt 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 Ø EV=Σ (Outcomei) (Pi) i. e. , summation of each outcome (in this case, income) times the probability of that outcome. Ø Suppose P(getting contract) =. 20 Ø Ø 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 Ø To maximize expected value, we keep old equipment. [read as “probability of getting contract =. 20”] 3 -5
Forest Product Companies and Timberland Ø Long-term capital-budgeting decisions More risk – Time value of money especially important Ø Typical decision: – Buy timberland now, or – Buy timber as needed – 3 -6
The basic decision Starting point in hypothetical case assumes indifference given the current regulatory environment, for simplicity only. 3 -7
Uncertainty: Regulatory environment may change Management’s estimates. 3 -8
Possible Regulatory Environments and Related Outcomes $6. 57. 0 $6 -4. 5 3 -9
Expected Values of the Two Actions 3 - 10
The End 3 - 11
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