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Uncertainty and Capital Budgeting ACCT 7320 , 12/4/13, BaileyPowerPoint Presentation

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

E Get Govt Income = Income =

v Contract $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.

Uncertainty: Regulatory environment may change

Difference in these two columns is NPVof buying now

Difference in these two columns is NPVof buying as needed.

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