Uncertainty and capital budgeting acct 7320 12 4 13 bailey
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Uncertainty and Capital Budgeting ACCT 7320 , 12/4/13, Bailey. This presentation contains two parts: A general model of decision-making under uncertainty, using “expected value”

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Uncertainty and Capital Budgeting ACCT 7320 , 12/4/13, Bailey

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Uncertainty and Capital BudgetingACCT 7320, 12/4/13, 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 Accounting Quarterly, Winter 2001


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.


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)


Example of DM under Uncertainty

Action Taken

Buy new Eqpt Keep old Eqpt

EGet Govt Income = Income =

vContract $500,000 $300,000

e

n Not get Govt Income = Income =

t Contract $10,000 $200,000

  • Which action is best?

    Depends on probabilities we assign to the events.


Decision Models and Uncertainty

  • EV=Σ(Outcomei) (Pi)

    i.e., summation of each outcome (in this case, income)

    times the probability of that outcome.

  • Suppose P(getting contract) = .20

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

  • 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

  • To maximize expected value, we keep old equipment.


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


The basic decision

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


Expected Values of the Two Actions


Uncertainty: Regulatory environment may change

Difference in these two columns is NPVof buying now

Difference in these two columns is NPVof buying as needed.


Possible Regulatory Environments and Related Outcomes

$6.5-7.0

$4.5-3


The End


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