TOPIC 5
DECISION RECOGNIZING
RISKS
Expected Monetary Value of Alternatives and Decision Tree
Analysis
TOPIC OUTLINE:
1
Introduction
2
Decision Recognizing Risks
3 Expected Monetary Value of Alternatives
4 Decision Tree Analysis
Decision Recognizing Risks
INTRODUCTION
Expected Monetary Value of Alternatives and
Decision Tree Analysis
INTRODUCTION
Engineers and economic analysts usually deal with estimates about
uncertain future by placing appropriate reliance on past data, if any exist.
This means that probability and samples are used.
Actually, the use of probabilistic analysis is not common as might
expected. The reason for this is not that the computations are difficult to
perform or understand, but that realistic probabilities associated with
cash flow estimates are difficult to assign. Experience and judgment can
often be used in conjunction with probabilities and expected values to
evaluate the desirability of an alternative.
Topic 5: Decision Recognizing Risks
Decision Recognizing Risks
Decision Recognizing Risks
•Risk-based decision making provides a process to ensure that optimal
decisions, consistent with the goals and perception of those involved are
reached.
•Risk is present when there may be two or more observable values for a
parameter and it is possible to estimate the chance that each value may occur.
•Decision making under risk is introduced when an annual cash flow estimate
has a 50-50 chance of being either -₱50,000 or ₱25,000.
Topic 5.1: Expected Monetary Value of Alternatives
Expected Monetary Value of
Alternatives
•Expected Monetary Value is a statistical concept that calculates the
average outcomes when the future includes the scenarios that may
or may not happen.
•The expected value can be interpreted as a long-run average
observable if the project is repeated many times.
•Since a particular alternative is evaluated or implemented only
once, a point estimate of the expected value results.
EXPECTED MONETARY VALUE OF ALTERNATIVES
The expected value E(X) is computed
using the relation
Where expected value is simply the
sum of the probability of a specific
value multiplied by its variable x.
Expected value = E(X)
Variable x = Xi
Probability of a specific value = P(Xi)
EXPECTED MONETARY VALUE OF ALTERNATIVES
•Probabilities are always correctly stated in decimal form,
but they are routinely spoken of in percentages and often
referred to as chance, such as the chances are about 10%.
•𝑋 represents the estimated cash flows. It can either be
positive or negative.
EXPECTED MONETARY VALUE OF ALTERNATIVES
• If a cash flow sequence includes revenues and costs, and the
present worth at the MARR (minimum acceptable rate of return)
is calculated, the result is the expected value E(PW) of the
discounted cash flows .
• If the expected value is negative, the overall outcome is expected
to be a cash outflow. For example, if E(PW) = - ₱76,500, this
indicates that the proposal is not expected to return the MARR.
Example #1
A downtown hotel is offering a new service for weekend travelers through its
business and travel center. The manager estimates that for a typical weekend,
there is a 50% chance of having a net cash flow of ₱250,000 and a 35%
chance of ₱510,000. He also estimates there is a small chance (5%) of no cash
flow and 10% chance of a loss of ₱25,000, which is the estimated extra
personnel and utility costs to offer the service. Determine the expected net
cash flow.
Let X be the net cash flow in pesos, and let P(X) represent the associated
probabilities.
E(X) = ₱250,000(0.50) + ₱510,000(0.35) + ₱0(0.05) - ₱25,000(0.10)
E(X) = ₱301,000.00
Example #2
An electric utility is experiencing a difficult time obtaining natural gas for
electric generation. Fuels other than natural gas are purchased at an extra cost,
which is transferred to the customer. Total monthly fuel expenses are now
averaging ₱395,000,000. A chemical engineer with this city-owned utility has
calculated the average revenue for the past 24 months using three fuel-mix
situations-gas plentiful, less than 30% other fuels purchased, and 30% or more
other fuels. The following table indicates the number of months that each fuel-
mix situation occurred. Can the utility expect to meet future monthly expenses
based on the 24 months of data, if a similar fuel-mix pattern continues?
Example #2
Using the data in months, the probabilities are as
₱ follow:
269,104,000
400,845,000
615,400,000
Let X be the net cash flow in pesos, and let P(X) represent the associated probabilities.
E(X) = ₱269,104,000(0.50) + ₱400,845,000(0.25) + ₱615,400,000(0.25) – 395,000,000
E(X) = - ₱6,386,750
If this pattern continues, the utility will no longer meet the future expenses.
Example #3
Lite-Weight Wheelchair Company has a substantial investment in tubular
steel bending equipment. A new piece of equipment costs ₱255,000 and has
a life of 3 years. Estimated cash flows shown in the table depend on
economic conditions classified as receding, stable, or expanding. A
probability is estimated that each of the economic conditions will prevail
during the 3-year period. Apply expected value and PW analysis to
determine if the equipment should be purchased. Use a MARR of 15% per
year.
Example #3
PW = (Investment cost) + (values in every year) (1 + % per year)-n
PWR = -255,000 + 125,000(1.15)-1 + 100,000(1.15)-2 + 50,000(1.15)-3
₱ = -₱37,814.16947
-255,000 -255,000 -255,000 PWS = -255,000 + 100,000(1.15)-1 + 100,000(1.15)-2 + 100,000(1.15)-3
= -₱26,677.48829
125,000 100,000 100,000
100,000 100,000 150,000 PWE = -255,000 + 100,000(1.15)-1 + 150,000(1.15)-2 + 175,000(1.15)-3
= ₱60,443.41251
50,000 100,000 175,000
Let X be the net cash flow in pesos, and let P(X) represent the associated probabilities.
E(X) = – ₱37,814.16947(0.2) – ₱26,677.48829(0.6) + ₱60,443.41251(0.2)
E(X) = - ₱11,480.64
The equipment is not justified since E(PW)<0.
Topic 5.2: Decision Tree Analysis
Decision Tree Analysis
Decision Tree Analysis
•Alternative evaluation may require a series of decisions where the outcome
from one stage is important to the next stage of decision making. When each
alternative is clearly defined and probability estimates can be made to
account for risk, it is helpful to perform the evaluation using a decision tree.
•In decision tree analysis, a problem is depicted as a diagram which displays
all possible actions, events, and payoffs (outcomes) needed to make choices
at different points over a period of time.
Decision Tree Analysis
•The decisions tree is constructed left to right and includes each possible
decision and outcome.
•A square represents decision node with the possible alternatives indicated on
the branches from the decision node.
•A circle represents a probability node with the possible outcomes and
estimated probabilities on the branches.
Decision Node Probability Node
Decision Tree Analysis
Since outcomes always follow decisions, the treelike structure will look like the one below.
Decision Tree Analysis
To construct a Decision Tree Analysis:
•Determine the PW value for each outcome branch considering the time
value of money.
•Calculate the expected value for each decision alternative.
where the summation is taken over all possible outcomes for each decision
alternative.
Decision Tree Analysis
To construct a Decision Tree Analysis:
•At each decision node, select the best E(decision) value-minimum
cost or maximum value (if both costs and revenues are estimated).
•Continue moving to the left of the tree to the root decision in order
to select the best alternative.
•Trace the best decision path back through the tree.
Example #1
A decision is needed to either market or sell a new (₱ million)
invention. If the product is marketed, the next
decision is to take it international or national.
Assume the details of the outcome branches result in
the decision tree given. The probabilities for each
outcome and PW of CFBT (cash flow before taxes)
are indicated. These payoffs are in millions of pesos.
Determine the best decision at the decision node D1.
Example #1
Computing the Expected Values:
(₱ million)
E(X) = 0.5(12) + 0.5(16)
E(X) = 14
E(X) = 0.4(4) + 0.4(-3) + 0.2(-1)
E(X) = 0.2
E(X) = 0.8(6) + 0.2(-3)
E(X) = 4.2
E(X) = 0.4(6) + 0.4(-2) + 0.2(2)
E(X) = 2
E(X) = 14(0.2) + 04.2(0.8)
E(X) = 6.16
Therefore, the best decision is to sell, not to
market a new invention.
