Uncertainty and Capital Budgeting

ACCT 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

3-1
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.

3-2
 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)

3-3
 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.
3-4
Decision Models and Uncertainty

EV= (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.

3-5
 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

3-6
 The basic decision

Starting point in hypothetical case assumes indifference

given the current regulatory environment, for simplicity only.

3-7
Uncertainty: Regulatory
environment may change

Managements estimates.

3-8
Possible Regulatory Environments
and Related Outcomes

$6.5-
7.0

$6-4.5

3-9
Expected Values of the Two Actions

3 - 10
The End

3 - 11