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

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

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

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- 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

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

- 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)

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.

- 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.

- Long-term capital-budgeting decisions
- More risk
- Time value of money especially important

- Typical decision:
- Buy timberland now, or
- Buy timber as needed

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

Difference in these two columns is NPVof buying now

Difference in these two columns is NPVof buying as needed.

$6.5-7.0

$4.5-3