Chapter 10: Decisions and Risk

2007 Pearson Education

Types of Business Decisions

Accepting or rejecting a proposal or project Selecting from a set of non-mutually exclusive alternatives Selecting the best decision from a set of mutually exclusive alternatives Choosing a best decision strategy when a sequence of choices and chances events may occur

Structuring Decision Problems

Potential alternative decisions Factory locations Products to introduce Investments Criteria by which to evaluate decisions Net profit Cost Environmental impact

Decisions Involving a Single Alternative

Net present value (NPV) n Ft NPV = t

t 0

(1 i )

Internal rate of return (IRR) IRR is the discount rate that makes the total present value of all cash flows zero: n F

(1 IRR )
t t 0

Example

Decisions Involving NonMutually Exclusive Alternatives

Ranking criteria Return on investment (ROI)

ROI Annual revenue annual cos ts initial investment

Cost/benefit ratios

Example

Decisions Involving Mutually Exclusive Alternatives

Scoring model - a quantitative assessment of a decision alternatives value based on a set of attributes.

Decisions Involving Uncertainty and Risk

Identify decision alternatives Identify possible outcomes or chance events Evaluate the payoff associated with each alternative and outcome (payoff table)
Market rises $600 $200 Market falls -$1500 -$500 $300 Market stable $0 $200 $100

Decision/Event

Aggressive fund $1000 Balanced fund Bond fund

The decision depends on how risk is valued.

Risk

The chance of an undesirable outcome.

Market rises Market falls Market stable

Decision/Event

Aggressive fund
Balanced fund Bond fund

$1000
$600 $200

-$1500
-$500 $300

$0
$200 $100

Little risk

Highest risk

Decision Strategies

Average payoff Aggressive Conservative Opportunity loss

Average Payoff
Decision/Event

Market rises $1000

Market falls -$1500

Market stable Average $0 -$166.67

Aggressive fund

Balanced fund
Bond fund

$600
$200

-$500
$300

$200
$100

$100
$200

Choose Bond fund

Aggressive Strategy
Decision/Event Market rises

Market falls -$1500

Market stable Best Return $0 $1000

Aggressive fund

$1000

Balanced fund
Bond fund

$600
$200

-$500
$300

$200
$100

$600
$300

Choose Aggressive fund

Conservative Strategy
Decision/Event Market rises

Market falls -$1500

Market stable Worst Return $0 -$1500

Aggressive fund

$1000

Balanced fund
Bond fund

$600
$200

-$500
$300

$200
$100

-$500
$100

Chose Bond fund

Opportunity Loss
Decision/ Event

Market rises Market falls

Market stable
$0 $200

Maximum Opportunity Loss

$1800

Aggressive fund

$1000 $0

-$1500 $1800

Balanced fund
Bond fund

$600 $400
$200 $800

-$500 $800
$300 $0

$200 $0
$100 $100

$800
$800

Choose either Balanced or Bond fund

Understanding Risk

Average payoffs never occur!

Market rises Market falls Market stable Average

Decision/Eve nt

Aggressive fund
Balanced fund Bond fund

$1000
$600 $200

-$1500
-$500 $300

$0
$200 $100

-$166.67
$100 $200

Less variation

More variation

Measuring Risk

Standard deviation Measures variation, but does not account for magnitude of return or loss Return to risk the ratio of mean return to the standard deviation Similar to the Sharpe ratio in finance

Which Project is Riskier?

Quantitative measures: Standard deviation Project A: $993.7 Project B: $1414.2 Return to Risk

Project A: 7.80
Project B: 5.656

Expected Value Decision Making

Average payoff strategy is appropriate for repeated decisions Real estate development Day trading Pharmaceutical research

Expected Monetary Value

Select the alternative with the best expected payoff

E ( Di ) P ( S j )V ( Di , S j )
j 1 n

where P(Sj) = the probability that event Sj occurs and n = the number of events.

PHStat Tool: Expected

Monetary Value

Example

EVPI

Expected opportunity loss - the average additional amount the investor would have achieved by making the right decision instead of a wrong one Expected value of perfect information (EVPI) - the maximum improvement in the expected return that can be achieved if the decision maker is able to acquirebefore making a decisionperfect information about the future event that will take place.

Example
EVPI = expected value of perfect information = minimum expected opportunity loss = 360. That is, by having perfect information, we can increase our expected return by at most $360

Portfolio Risk Analysis

Portfolio - a collection of assets, such as stocks, bonds, or other investments, that are managed as a group. Objective: maximize expected return while minimizing risk Expected return = wE[X] + (1-w)E[Y] w = fraction of portfolio for asset X 1 w = fraction of portfolio for asset Y Standard deviation

P w (1 w) 2w(1 w) XY
2 2 X 2 2 Y

PHStat Tool: Covariance and

Portfolio Analysis
Data table for risk evaluation
X-Weight 0 0.1 0.2 Change weight to 0.3 0.4 evaluate different 0.5 scenarios 0.6 0.7 0.8 0.9 1 Expected Portfolio Return Risk 230 685.638 $ 200 953.939 $ 206 900.269 $ 212 846.603 $ 218 792.941 $ 224 739.286 $ 230 685.638 $ 236 632.000 $ 242 578.374 $ 248 524.763 $ 254 471.173 $ 260 417.612

The Newsvendor Problem

Single period purchase decision Purchase goods for $c Sell goods for $r Unsold goods sold for $s d = Demand during period x = number purchased How many goods should be purchased to maximize the expected profit?

General Model

Case 1: x d Profit = rd + s(x - d) cx Case 2: x < d Profit = rx - cx = (r - c)x Expected Profit =

d x 1

[rd s( x d ) cx] p(d ) [( r c) x] p(d )

d 0

Example and Spreadsheet Solution

Maximum expected profit

The Flaw of Averages

If y = f(x) represents a generic decision model, then E[y] is not necessarily equal to f(E[x]). In other words, you cannot use the average value of an input in a model to determine the expected output.

Decision Trees

Decision trees model a sequence of decisions and chance events. Nodes points in time at which events take place Decision (choice) nodes Event (chance) node Branches choices or outcomes A decision strategy is a specification of an initial decision and subsequent decisions that are contingent on the occurrence of events. A decision strategy has an associated payoff distribution, called a risk profile, that shows possible payoffs and their probabilities.

TreePlan: Excel Decision Tree Add-In

Sensitivity Analysis in Decision Trees

Utility and Decision Making

Utility theory an approach or assessing risk attitudes quantitatively by quantifying a decision makers relative preferences for particular outcomes.

Example
Decision/Event Bank CD Bond fund Rates rise $400 -$500 Rates stable $400 $840 Rates fall $400 $1000

Stock fund

-$900

$600

$1700

Using expected values, the stock fund is best, but this does not account for risk. Convert monetary payoffs into utility measures.

Process

Rank payoffs from highest to lowest For each payoff x, Suppose you have the opportunity of achieving a guaranteed return of x, or taking a chance of receiving $1,700 (the highest payoff) with probability p or losing $900 (the lowest payoff) with probability 1 - p. What value of p (the utility) would make you indifferent to these two choices?

Decision Tree Lottery for $1000 Payoff

Utility Function and Decision

Use utilities to compute expected values of each decision

On the basis of expected utility, the Bank CD is now the best decision.

Risk Averse Utility Function

Exponential Utility Functions

Often used to approximate risk-averse utility functions

U ( x) 1 e x / R

Finding R

Find the maximum payoff $P for which the decision maker is willing to take an equal chance on winning $P or losing $P/2. This is the value of R.

Example

Suppose R = 400