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Decision Models and Uncertainty in Capital Budgeting

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Learn about decision-making under uncertainty using the "expected value" model and managing capital budgeting risk with decision trees. Explore rational approaches to decision models and assumptions with examples to understand how to maximize expected value.

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Decision Models and Uncertainty in Capital Budgeting

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  1. Uncertainty and Capital BudgetingACCT 7320, 12/8/09, 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

  2. 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.

  3. 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)

  4. 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.

  5. 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.

  6. 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

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

  8. Uncertainty: Regulatory environment may change Management’s estimates.

  9. Possible Regulatory Environments and Related Outcomes $6.5-7.0 $6-4.5

  10. Expected Values of the Two Actions

  11. The End

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