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

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

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

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

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 uncertainty1

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

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

The basic decision

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


Expected values of the two actions

Expected Values of the Two Actions


Uncertainty regulatory environment may change

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

Possible Regulatory Environments and Related Outcomes

$6.5-7.0

$4.5-3


The end

The End


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