COMMONLY USED TECHNIQUES AND MODELS IN ASSESSING

INVESTMENT ALTERNATIVES UNDER RISK OR UNCERTAINTY


1. Probability
2. Value of Information
3. Sensitivity Analysis
4. Simulation
5. Decision Tree
6. Standard Deviation & Coefficient of
Variation
7. Project Beta
PROBABILITY

 PROBABILITY

Decision Making under
Certainty

Decision Making under

Uncertainty
 DECISION MAKING
UNDER CERTAINTY

 for each decision action there is
only one event and therefore
only a single outcome for each
action.
 DECISION MAKING
UNDER UNCERTAINTY

 involves several events for each
action with its probability of
occurrence.
 ASSIGNING
PROBABILITIES

 ASSIGNING PROBABILITIES


 A probability distribution describes
the chance or likelihood of each of
the collectively exhaustive and
mutually exclusive set of events.
1. Mutually Exclusive- if two events cannot
occur simultaneously.
2. Joint Probability- that two events will
both occur.
3. Conditional Probability of two events- is
the probability that one will occur given that
the other has already occurred.
4. Independent- if the occurrence of one has
no effect on the probability of the other.
Illustrative Case 21-1.Decision
Making under Uncertainty

M & O Corporation is considering two new
designs for their kitchen utensil products – Product
A and Product B. Either can be produced using the
present facilities. Each product requires an
increase in annual fixed costs of P4, 000,000.00.
The products have the same selling price of P1,
000 and the same variable cost per unit P800.
 After studying past experience with similar products,
management has prepared the following probability
distribution:

Event Probability for
(Units Demanded) Product A
Product B
5,000 0.0 0.1
10,000 0.1 0.1
20,000 0.2 0.1
30,000 0.4 0.2
40,000 0.2 0.4
50,000 0.1 0.1
1.0 1.0
Management would like to know:

a) The break-even point for each product.

b) Which product should be chosen, assuming the

objective is to maximize expected operating income?
Solution:

a) Since both products have the same contribution
margin per unit of P200 (P1 ,000-P800) break-
even point for each product will be the same
computed as follows:
Break-even point = P4, 000,000/P200
= 20,000 units
Solution:
b) (1) Determine the expected demand for the two
products: 
Event Product A Product B
Demand Probability Units Probability
Units
5,000 0.0 0 0.1 500
10,000 0.1 1000 0.1 1,000
20,000 0.2 4,000 0.1 2,000
30,000 0.4 12,000 0.2 6,000
40,000 0.2 8,000 0.4 16,000
50,000 0.1 5,000 0.1 5,000
1.0 30,000 units 1.0 30,500 units
Solution:
b) (2) Compute the expected operating income of
the two products.

Product A Product
B Sales P30, 000,000
P30, 500,000 Variable Costs 24,000,000
24,400,000 Contribution Margin P 6,000,000
P 6,100,000
Fixed Costs 4,000,000
4,000,000 Operating Income P 2,000,000
P 2,100,000

**Product B should be chosen because of the higher

expected income compared with product A.
 Payoff (Decision) Tables

 Payoff (decision) tables are helpful tools for identifying
the best solution given several decision choices and
future conditions that involve risk.
 A payoff table represent the outcomes (payoffs) of
specific decisions when certain states of nature (events
not within the control of the decision maker) occur.
Example: A dealer in luxury yachts may order 0, 1, or 2
yachts for this season’s inventory. The cost of carrying
each excess yacht is P50, 000, and the gain for each yacht

sold is P200, 000. The situation may be described by a
payoff table as follows:

State of nature =
Season’s Actual Decision = Decision =
Decision =
Demand Order 0 Order 1 Order
2
0 yacht 0 P (50,000) P (100,000)
1 yacht 0 200,000 150,000
2 yachts 0 200,000 400,000
The probabilities of the season’s demand are
Pr Demand
0.10 0
0.50
0.40  1
2
The dealer may calculate the expected value of each decision as follows:

Order 0 Order 1 Order 2

0.1 x 0 0.1 x P (50,000) 0.1 x P
(100,000)
0.5 x 0 + 0.5 x 200,000 + 0.5 x 150,000
0.4 x 0 + 0.4 x 200,000 + 0.4 x 400,000
EV (0) = 0 EV (1) = P175, 000 EV (2) = P 225,
000

**The decision with the greatest expected value is to order two yachts, so, in
the absence of additional information, the dealer should order two.
Perfect Information- is the knowledge that a future state
of nature will occur with certainty,ie, being sure of what
will occur in the future

Expected value of perfect information- is the difference
between the expected value without perfect information
and the return if the best action is taken given perfect
information.

-The expected value of perfect information is the amount

the company is willing to pay for the market analysts’
errorless advice.

EVPI=EVwPI-EVwoPI (maximum EMW)

 
“perfect information” is not perfect in the sense of
absolute predictions.
-We can sometimes reduce the uncertainty involved in
making a decision by collecting more information.
-The value of perfect information tells us the maximum
amount it is worth paying for it.
Information can be obtained from various
sources,such as the following:

1. Market research surveys
2. other surveys or questionnaire
3. conducting a pilot test
4. Building a prototype model




 

The dealer expects to make 260,000 with perfect

information about future demand, and 225,000 if the
choice with the best expected value is made. The
expected value of perfect information (EVPI) is then
Expected value with perfect information P 260,000
Expected value of the best choice (225,000)
EVPI P 35,000
 
The dealer will not pay more
than 35, 000 for information about
future demand because it would
then be more profitable to make
the expected value choice than to
pay more for the information.
 Illustrative Case
Adventure Corporation has three

investment opportunities, each one yielding
different profits depending on the state of the
market. The managing director has estimated
that the probabilities of the three states
occurring area as follows:
State Probability
I 0.5
II 0.2
III 0.3
The payoff table showing the incremental
profits with each project is as follows:

Market State In (P000’s)
I II III
Project A 75 20 5
Project B 45 80 55
Project C 35 60 90
 
1. What should be undertaken? Ignore risk
and use the decision rule that the project
with the highest Expected Value of
profits should be taken.

2. What would be the value of perfect

information about the state of the
market? Would it be worth paying
P15,000 to obtain this information?
 Project A Project B Project C
Market Probabil Profit
 EV Profit EV
State ity Profit EV
In (P000’s)
I 0.5 75 37.5 45 22.5 35 17.5
II 0.2 20 4.0 80 16.0 60 12.0
III 0.3 5 1.5 55 16.5 90 27.0
EV of 43.0 55.0 56.5
Profit
 
Project C should be
undertaken (ignoring risk)
because it has the highest
Expected Value of profits.
With Perfect information about the future state
of the markets, the company would choose the
most profitable project for the market state

which the perfect information predicts will
occur.
(i) If State I is forecast, Project A would be
chosen: P75,000
(ii)If State II is forecast, Project B would be
chosen: P80,000
(iii)If State III is forecast, Project C would
be chosen: P90,000
 EV of Profits Information is given

Market
State

Choose Profit in Probabil EV in
(P000’s) ity (P000’s)

I A 75 0.5 37.5
II B 80 0.2 16.0
III C 90 0.3 27.0
EV of Profits, with Perfect Information
80.5
 
Since the EV of profits without
information is P56,500 (choosing
project C), the value of perfect
information to the company is
(P80,500 - P56,500=P24,000)and the
cost of information is P15,000, it
would be worthwhile to obtain it.
Sensitivity analysis describes
how sensitive the linear
 solution is
programming optimal
to a change in any one number.
Sensitivity analysis answers
what-if questions about the effect
of change in prices or variable
cost; changes in value; addition
or deletion of constraints; and
changes in industrial coefficients.
A trial-and-error method may be adopted in which the
sensitivity of the solution to changes in any given
variable, parameter, or other assumption is
calculated.

 The risk of the project being simulated may also be
estimated.
 The best project may be one that is least sensitive to
changes in probalistic inputs.
 A sensitivity analysis may indicate whether
expending additional resources to obtain better
forecasts of future conditions is cost justified.
 
In linear programming problems, sensitivity
is the range within which a constraint value,
such as a cost efficient or any other variable,
may be changed without changing the optimal
solution. Shadow price is the synonym for
sensitivity in that context.
Financial planning models, including those
for cash flows and capital budgeting are
other significant applications of sensitivity
analysis.
 Illustrative Case 21-3.
Application of Sensitivity Analysis

Mirmo Company has prepared the following budgeted
profitability statement for the current year operations:
Sales (2,500 units x P40) P100,000
Variable cost:
Materials P40,000
Labor 30,000 70,000
Contribution margin 30,000
Less: Fixed cost 20,000
Profit P10,000

Required:
Make sensitivity analysis based on the above data.
Solution:
1. If selling price is reduced by more than 10% budgeted,


the company would incur loss.
2. If the sales are reduced by more than 10% of the
budgeted sales of 2,500 units, the company would incur
loss.
3. If labor cost increase by more than 33.33% above the
budgeted, the company would make a loss.
4. If material cost increases by 25% or more of the
budgeted cost, the company would make a loss.
5. If the fixed costs increase by more than 50% of the
budgeted fixed cost, the company would incur loss.

If we observe the sensitivity of the above data, sales units and

selling price per unit are more sensitive than the costs. This vital
information should be considered in making the final decision
regarding policies on pricing and cost control.
SIMULATION

 
Is a technique for experimenting with
logical and mathematical models
using a computer
EXPERIMENTATION

Is neither new nor uncommon
business
Is organized trial and error using a
MODEL of the real world to obtain
information
MODELS

 Physical models
- include automobile mockups, airplane models
used for wind-tunnel tests and breadboard models of
electronic circuits.
 Abstract models
- may be pictorial, verbal or logical-mathematical.
SIMULATION
PROCEDURE

 FIVE STEPS
1. Define the objectives
2. Formulate the model
3. Validate the model
4. Design the experiment
5. Conduct the simulation
1. Define the objectives 
 Serve as a guidelines for all that follows
 Aid in the understanding of an existing
system or to explore alternatives
 Estimating the behavior of some new
system such as a production line
2. Formulate the model
 The variables to be included, their
individual behavior, and their
interrelationships must be defined in
precise logical-mathematical terms
3. Validate the model


 Assurance requires validation of the
model-often using historical data
4. Design the experiment
 Experimentation is sampling the
operation of a system
5. Conduct the simulation- evaluation results
 The simulation should be conducted
with care
 The results are analyzed using
appropriate statistical methods
 ADVANTAGES AND
LIMITATIONS OF SIMULATION

Advantages
 Time can be compressed
 Alternative policies can be explored
 Complex systems can be analyzed
Limitations
 Cost
 Risk of error
 Illustrative Case 21-4. Simulation
Technique

The financial controller of Minitoons, lnc. has
drawn the following projections with
probability distributions:
Wages and Probability Raw Probability Sales Probability
Salaries Material Revenue
(P000's) (P000's) (P000's)

10-12 .3 6-8 .2 30-34 .1

12-14 .5 8-10 .3 34-38 .3

14-16 .2 10-12 .3 38-42 .4

12-14 .2 42-46 .6
Requirement:

Simulate the cash flow projection and expected cash balance

at the end of the sixth month. Use the ff. random numbers.

Wages 2 7
9 2 9 8
and
salaries
(P000's)
Raw 4 4 1 0 3 4
materials
(000's)
Sales 0 6 6 7 0 2
revenue
(P000's)

Fixed cost=14,000/month
 Solution:
a. Simulation of Cash Flow Projection

Random Number 
Allocation
Wages and Salaries Raw Materials Values Revenue
Mid- Cumula Rando Mid- Cumul Rando Mid- Cumul Rando
point tive m point ative m point ative m
(P000's) probabi numbe (P000's probab numbe (P000's probab numbe
lty rs ) ilty rs ) ilty rs

11 .3 0-2 7 .2 0-1 32 .1 0

13 .8 3-7 9 .5 2-4 36 .4 1-3

15 1.0 8-9 11 .8 5-7 40 .8 4-7

13 1.0 8-9 44 1.0 8-9

 b. Expected Value Method of
Cash Projection

EV of salaries and Wages= (11×0.3) + (13×0.5) + (15×0.2)=12,800

EV of raw materials= (7×0.2) + (9×.03) + (11×0.3) + (13×0.2)= 10,000

EV of sales revenue= (32×0.1) + (36×0.3) + (40×0.3) + (44×0.2)= 34,800

Expected net cash inflow per month= 34,800-12,800-10,000-14,000=2,000

Expected cash balance after 6 months = 50,000 + (2,000×6)= 62,000

 Underlying Concept

Decision tree - is an analytical tool
used in a problem in which a series
of decision has to be made at
various time intervals, with each
decision influenced by the
information that is available at the
time it is made.
 ADVANTAGES OF DECISION TREE
ANALYSIS
 Decision tree is an effective means of
presenting the relevant information needeed by
the management in an investment problem.
Combination of action choices with different
events or results of action that chance or other

uncontrollable circumtances partially affect can
be better presented and studied.
The interactions of the impact of future
events,decision alternatives, uncertain events and
their possible payoffs can be shown with greater
ease and clarity.
 
Data are presented in a manner
that enables systematic analysis
and better decision.
 LIMITATION OF DECISION
TREE ANALYSIS

 A decision tree does not give management the
answers to an investment.
 It does not identify all the possible events or does it
list all the decisions that must be made on a subject
under analysis.
 The interactions of such decision with the objective
of other parts of the business organization would be
too complicated to compute manually.
 Decision tree analysis treats uncertain alternatives as
if they were discrete well-defined possibilities.
 STEPS IN MAKING A
DECISION TREE

1. Identification of the points and the alternatives
available at each point.
2. Determination of the points of certainty and the type or
range of alternative outcomes at each point.
3. Estimates of the probabilities of different events or
results of actions.
4. Estimates of the costs and gains of various events and
actions.
5. Analysis of the alternative values in choosing a course
of action.
 Competitors come in
Figure 21-1 Decision Tree
Competitors stay
out

Decision 2
Success Competitors come in

Postpone
Launch
Continu Competitors stay out
e Project
Immediately Launch

Decision 1 Failure  Competitors come

in

Competitors stay out

Abort
Project Competitors come in

Competitors stay
out
 Illustrative Case 21-5. Decision
Tree
with Qualified Outcomes.

Immediately
Launch
Competitors come in

Competitors come out

Project Competitors come in

Success
Postpone
Competitors come out
Launch
Continue
Project Competitors come in
Failure
Competitors come out
Project

Competitors come in
Abort
Project
Competitors come out
1. It will cost an estimated P50,000 to continue the
project which itself probabilistic.

2. If the company decides to postpone the launch of

the product (assuming the project is successful)
and competitors enter the market, there will be
a loss of current business amounting to P125,000.

3. If the project is successful and an immediate

launch is undertaken, the company will generate
incremental cash flows of P450,000 if
competitors stay out of the market, but only
P250,000 if competitors enter the market
P250,000 x 0.7 P175,000
P450,000 x 0.3 135,000
Expected Value (EV) P310,000
P310,000 x 0.6 P186,000
-(75,000) x 0.4 (30,000)
Expected Value (EV) P156,000
 EV Competitors come in
P310,000 (0.7) + P250,000
Immediately Competitors come out
Launch + P450,000
(0.3)
Project Competitors come in
EV Success (0.5)
Postpone - P175,000
P156,000 0.6 Launch Competitors come out
EV (0.5) - P50,000
Continue -P112,500
Project Competitors come in
Failure - P175,000
(0.2)
0.4
EV Competitors come out
Project - P50,000
-P75,000 (0.8)
Competitors come in
Abort
(0.5) - P125,000
Project
Competitors come out
EV
(0.5) P0
-P62,500