Chapter 24 Decision Making Under Uncertainty Learning Objectives After studying this chapter, you will be able to: 1. Define probability and conditional value. 2. Compute the expected value of an event given a probability distribution. 3. Compute the variance and the standard deviation of the expected value. 4, Define and compute the coefficient of variation. 5. Prepare a payoff table and determine the best strategy under conditions of uncertainty. 6. Compute the expected value of perfect information. 7, Revise probabilities on the basis of new information and construct a revised payoff table. 8. Construct and use decision trees to determine the best alternative course of action. 9. Compute the expected net present value and the standard deviation of the net present value for capital expenditure proposals. 10. Use multiattribute decision models that specifically consider both quantitative and non- quantitative factors in the decision. In practice, most decisions are based on a single best guess about the future. Although decision makers recognize that the future is uncertain, formal attempts to incorporate uncertainty into the decision are rare. Instead, the problem of uncertainty is handled by tempering the decision with business judgment and a “feel” for the uncertainty inherent in the data. As a result, many biased and naive decisions are made. A better approach to dealing with uncertainty is to incorporate the likelihood of alter- native outcomes into the decision model. This approach is sometimes referred to as prob- ability analysis. Probability analysis is an application of statistical decision theory that, under conditions of uncertainty, leads to more consistent and reliable decisions than single best guesses. Probabilities based on available information are used to improve the quality of management decisions. ‘This chapter begins by defining probability and explaining how probabilities can be obtained and used in decision making. These concepts are extended through illustrations of payoff tables and decision trees for decision making under uncertainty, The next section demonstrates the use of the normal distribution in evaluating risk of short-term projects. It is followed by a brief explanation of Monte Carlo simulations. The last two sections of the chapter discuss and illustrate the use of the normal distribution to evaluate the riskiness of capital expenditure proposals and the use of the multiattribute decision model to incorpo- rate quantitative and qualitative factors into the analysis. Using Probabilities in Decision Making A probability is a number between 0 and | representing the likelihood that a particular event will occur, For recurring events, probability may be thought of as the relative frequency of different events. Probability may be observable in the sense that historical events exhibit a 24-1Part 5 > Analysis of Costs and Profits frequency pattern, or conceptual in the sense that future events are expected to follow some frequency pattern. Alternatively, a probability can be thought of as the degree of belief about the outcome of a nonrecurring future event, such as the probability that the govern- ment will deregulate a particular industry before the end of the year. In either case, prob- abilities are no more accurate than the data or subjective estimates on which they are based. Nevertheless, incorporating probabilities into decisions is a systematic way to eval- uate effects of alternative outcomes. For some decisions, a wealth of reasonably reliable historical data permits assigning fairly objective probabilities. As long as the underlying processes do not change in the future, historical data can be used to model probability distributions. For example, the actual historical demand for a particular product can be a good predictor of future demand as long as consumer tastes and preferences, the capacity of consumers to purchase the product, and the price and availability of competitive products do not change. If competi- tors introduce @hew and better product, however, future demand for the old product is likely to decline, which in turn means that the frequency distribution of historic demand is not a very reliable model of the probability distribution of future demand. ‘The use of probabilities in decision making under uncertainty is illustrated as follows. ‘Assume that Maxan Company's contribution margin is $10 per unit sold. A study of a 40- month period reveals that sales demand is random; that is, demand is irregular with no dis- cernible trend or pattern. If no change is expected in the underlying process that generates demand for the product (that is, the action of competitors and the capacity and desire of con- sumers to purchase the product are not expected to change), experience is a reasonable basis for predicting the future. The relative frequency of the occurrence of each level of sales demand during the sample period can be used as a measure of the probability of the occur- rence of each level of sales demand in the future (denoted as P(x,), where x, is the i" event). The sum of the probabilities of all possible events must equal 1, i.e., 2 1. If the sum of the probabilities of the events is less than 1, some event other than those included in the distribution can occur. Once the probability distribution for demand has been determined, the expected contri- bution margin from sales of the product, E(x) (referred to as the expected value), is deter- mined by adding the products of the contribution margin for each possible level of sales, x, (referred to as the conditional value), multiplied by the relative probability of its occur- rence, P(x;). That is, E(x) = Z[x, P(x]. The computation is illustrated in Exhibit 24-1. Maxan Company _ _Expected Value (Contribution Margin) of Monthly Sales q) (2) 2 ) @) (5) (6) x; Unit Historical i 2 Sales Frequency Contribution Conditional Expected each in Margin Value Month Month Probebity §—perUnt yea) @x6 4,000 8 40 $10 $40,000 $ 8,000 5000 10 ~—-1040 10 50,000 12,500 60001212140 10 80,000 18,000 7,000 6 6/40 10 70,000 10,500 | 800g 4/40 10 80,000 __8,000 | a 449 $57,000 EXHIBIT 24-1Chapter 24 > Decision Making Under Uncertainty 243 ‘The expected value in this illustration can be thought of as the average contribution margin that the company can expect in the future, based on past experience. The expected value is the mean of the probability distribution. If several alternative projects are being evaluated, the alternative with the largest expected average contribution margin and, con- sequently, the largest expected total contribution margin in the long run. However, man- agement may be concerned not only about profitability but also about risk. The variance and the standard deviation are measures of dispersion commonly used as measures of risk. The variance of a probability distribution is defined as Cad DPCx)[x,- EQOF, and the standard deviation (denoted o) is the square root of the vari- ance. Each provides a numerical measure of the scatter of the possible conditional values around the expected value. The greater the dispersion, the greater the likelihood, and con- sequently the greater the risk, that the actual value (contribution margin in the illustration) will differ materially from the expected value. Computation of the standard deviation for Maxan Company monthly sales is illustrated in Exhibit 24-2, Maxan Company ‘Standard Deviation of the Expected Value (Contribution Margin) of Monthly Sales ® @ (4) © fyceo Os - EWI Pi) PUx)x,- EGP ce . 13,000 Probabl $(17,000) x 20 25 30 15 23,000 10 (2) Squared $289,000,000 (7,000) 49,000,000 '3,000 9,000,000 169,000,000 529,000,000 ‘Standard deviation (0) = /$151,000,000 = $12,288 EXHIBIT 24-2 If alternative expected values are being compared, such as the expected contribution margins for several different products, the relative riskiness of each alternative cannot be determined by simply comparing standard deviations. Because of the difference in the magnitudes of the expected values, an alternative with a large expected value is expected to have a larger standard deviation than an alternative with a small expected value. The problem of comparing the relative riskiness of alternatives can be resolved by computing and comparing the coefficient of variation, which is the ratio of the standard deviation of a probability distribution to its expected value. The coefficient of variation compensates for differences in the relative size of expected values involved. For the Maxan Company illustration, the coefficient of variation is computed as follows: Coefficient _ Standard deviation (o) 12.288 _ o> of variation = Expected value (contribution margin) E(x) ~ $57,000 ~ “4-4 Part 5 > Analysis of Costs and Profits If another product has an expected contribution margin of $100,000 and a standard deviation of $18,000, the relative risk, as measured by the coefficient of variation, is less than for the product first illustrated ($18,000 + $100,000 = .18, compared with .22) even though the standard deviation is larger ($18,000 compared with $12,288). Determining the Best Strategy Under Uncertainty Probabilities are especially useful in determining the best course of action under condi- tions of uncertainty. The course of action selected can be thought of as the decision maker's strategy for achieving some goal—maximizing profits, minimizing losses, or increasing market share. Payoff tables and decision trees are useful tools in determining the best strategy under uncertainty. Payoff Tables ‘When several courses of action are being considered, a payoff table can be constructed to determine the best strategy. A payoff table is a table that presents both the conditional value of each event that can occur for each course of action being considered and the expected value of each alternative based on the probabilities of the events that can occur. For illustrative purposes, assume that the manager of City Bakery must decide how many loaves of bread to bake each day. The normal sales price is $1 a loaf. However, the price of bread not sold on the day of delivery is reduced to $.30 a loaf. The variable cost of producing and distributing a loaf of bread is $.40. An additional cost of $.10 is incurred in distributing and selling each loaf at the reduced price. The unit contribution margin is computed as follows: Regular sales price $1.00 Reduced sales price $30 Less variable cost 40 Less: Variable cost. $.40 Unit contribution margit Additional at regular sales price... $60 distribution cost. 10 _.50 Unit loss at reduced price... $20) Over the past 360 days, the company has experienced the following random sales demand (that is, there are no cycles or trends in sales demand): Unit Sales Number of per Day Days 10,000 72 11,000, 108 12,000 144 13,000 36 ao If sales demand in the future is expected to be the same as in the past, a payoff table can be constructed to determine the expected value of producing enough bread to satisfy each level of demand. The payoff table for City Bakery’s bread production is presented in Exhibit 24-3. Each conditional value is the contribution margin expected when City Bakery produces the number of loaves listed in the left-hand column and customer demand is equal to the quantity shown at the head of the column. The expected value of producing bread in each of the four quantities is listed in the right-hand column. The expected valueChapter 24 > Decision Making Under Uncertainty 24-5 of each action is determined by multiplying each conditional value by the probability of its occurrence and then summing the products. The results for City Bakery indicate that the best strategy in the long run is to produce 12,000 loaves of bread each day, because such a strategy results in the largest average expected profit. City Bakery Payoff Table for Alternative Quantities of Bread Production Possible Actions Contribution Margin (Conditional Value) Contribution Margin Possible Sales Quantities (Quantities to Expected Value of Be Produced) 10,000 11,000 12,000 13,000 Each Strategy) 10,000 $6,000" $6,000 $6,000 $6,000 $6,000 11,000 5800" 6,600 6,600 6,600 6,440 12,000 5600 6,400 7,200 7,200 6,640 13,000 5.400 6,200 _7,000 _7,800 6520°* Probability 20 30 40 10 * 10,000 units at the regular sales price x $.60 CM per unit = $6,000 conditional value. ** (10,000 units at the regular price x $.60 CM per unit) ~ (1.000 units at the reduced price x $.20 loss per unit) = $5,800 conditional value. *** (20 probability x $5,400 CM) + (.30 probability x $6,200 CM) + (.40 probability x $7,000 CM) + (10 probability x $7,800 CM) = $6,520 expected value. EXHIBIT 24-3 As in the previous illustration, the standard deviation and the coefficient of variation can be computed for each strategy. To illustrate the computations, the standard deviation and the coefficient of variation for the strategy with the largest expected value (the 12,000- loaf daily production level) is presented in Exhibit 24-4, City Bakery Standard Deviation and Coefficient of Variation For 12,000-Loat Daily Production Level a) @) @) @ © %; [y- EQ) (x; EXIF Pix) PO x) EQIP Difference from $6,640 Conditional Expected Value (2) Squared Probability (3). (4) $(1,040) $1,081,600 20 $ 216,320 (240) 57,600 30 17,280 560 313,600 40 125,440 3 Standard deviation (0) = /$390,400 = $625 Standard deviation (2) $625 Coefficient _ = = contribution margin [E(x)] $6,640” of Variation ~ Expecti EXHIBIT 24-4Chapter 24 > Decision Making Under Uncertainty wA-7 Revising Probabilities. Probabilities should be revised as new information becomes available. One approach to probability revision is an application of Bayes’ theorem. However, before Bayes’ theorem is presented, the following additional notation is needed: 1. Let P(A), P(B), and P(C) be the symbols for the probabilities of the occurrence of events A,B; and C, respectively. Let P(AB) be the symbol for the probability of the occurrence of both event A and event B, and let P(BC) be the symbol for the probability of the occurrence of both event B and event C. 3. Let P(AIB) be the symbol for the probability of the occurrence of event A given the occurrence of event B, P(BIA) be the symbol for the probability of the occur- rence of even B given the occurrence of event A, and P(BIC) be the probability of the occurrence of event B given the occurrence of event C. 2 P(AB) and P(BC) are referred to as joint probabilities. P(AIB), P(BIA), and P(BIC) are referred to as conditional probabilities; that is, the events enclosed in parentheses are not independent, but instead are related in some way. If P(AIB) < 1.0 and P(BIA) < 1.0, then A can occur without the occurrence of event B, and B can occur without the occur- rence of event A; however, assuming that P(AIB) > 0 and P(BIA) > 0, there is some possi- bility that both events will occur because there is some logical link between the two events. For example, a company can introduce a new product before the end of the year (event A) without hiring any new employees, and the same company can hire new employees (event B) without introducing a new product, but it is also quite possible that the company will hire new employees to have sufficient capacity to be able to produce a new product. In this case, because event A and event B are not independent events, P(AB) = P(BIA)P(A) = P(AIB)P(B). The joint probability of A and B is equal to the conditional probability of the ‘occurrence of B, given the occurrence of A, multiplied by the probability of the occurrence of A, which is also equal to the conditional probability of the occurrence of A, given the ‘occurrence of B, multiplied by the probability of the occurrence of B. Now assume that event C is the event that will occur if event A does not occur; that is, event C is that the company in the example will not introduce a new product before the end of the year, In this case, event C and event A are mutually exclusive; the company either will or will not introduce a new product before the end of the year. However, both event C and event B can occur; the company can hire new employees but not introduce a new prod- uct. The Venn diagram in Figure 24-1 illustrates this relationship. PIA) =.5 P@)=4 PC)=5 P(AB) = 3 P(@C) =.1 FIGURE 24-1 Venn Diagram Illustrating Joint ProbabilityPart 5 > Analysis of Costs and Profits Expected Value of Perfect Information. Sometimes it is possible to acquire additional information that will be useful in selecting the best alternative. Information, however, like any good or service, is costly. For example, the baker in the City Bakery illustration could conduct a market survey, which would improve the prediction of consumer demand. However, a market survey costs money. Before such a decision is made, the cost of the additional information should be weighed against the increase in the expected value that can be obtained by using the information. If the increase in the expected value to be derived from the use of the additional information is greater than the cost, the cost should be incurred. Otherwise, it should not. In actual practice, it is difficult to determine the value of information about a future event until the event has occurred. A market survey would probably result in a better estimate of demand but not a perfectly accurate prediction. On the other hand, it is pos- sible to compute the maximum expected value of additional information by computing the expected value under conditions of certainty and comparing it with the expected value of the best strategy under uncertainty. The expected value under conditions of cer- tainty is the expected value when the probability distribution is an accurate representa- tion of the relative frequency of future demand and the decision maker knows exactly when each possible event will occur. The maximum increase in the expected value that can be obtained from additional information is the expected value of perfect information and, Consequently, the maximum amount one would be willing to pay for additional information. In the City Bakery illustration, the expected value of perfect information is the differ- ence between (1) the average contribution margin if the manager knows the sales demand for bread each day with certainty (and consequently produces exactly the amount demanded) and (2) the average expected contribution margin using the best strategy under uncertainty. The expected value of perfect information is computed in Exhibit 24-5. The results indicate that management can afford to pay up to $200 per day for perfect informa- ion, because with perfect information the contribution margin is expected to increase an average of $200 a day. While perfect information is generally not available, this analysis determines the upper limit of the value of additional information. City Bakery Expected Value of Perfect Information @) x Contribution rg (Conditionat Value) 11,000 12,000 13,000 Expected value (cntinton lon marge) wih perfect certainty. Less the expected value (cortrbuon marg) of he best sratogy Under unoeranty proccson of 12,000 loaves per day).... Expected value of perfect information (on a per-day basis)... EXHIBIT 24-5Part 5 > Analysis of Costs and Profits ‘The rectangle labeled A and the rectangle labeled C represent events A and C, respec- tively, which in this case are of equal size and, therefore, have an equal chance of occurring. Because event A and event C together occupy all of the area in the Venn diagram and do not overlap, one or the other must occur, but not both. Therefore, P(A) + P(C) = .5+.5=1.The circle in the Venn diagram represents P(B), which in this case is .4. The portion of B that overlaps A is the joint probability of the occurrence of both A and B; that is, P(AB), which is .3. Similarly, the portion of B that overlaps C is the joint probability of the occurrence of B and C; that is, P(BC), which is .1. Thus, P(B) = P(AB) + P(BC) = 3+ .1 = 4. Recall from the preceding discussion that P(AB) = P(A|B)P(B). Because P(AB) and P(B) are both known in this situation, P(AIB), which is the conditional probability of the occurrence of event A given the occurrence of event B, can be determined by dividing both sides of the equation by P(B), as follows: P(AIB) = ae In terms of the Venn diagram in Figure 24-1, this result means that 75 percent of the area occupied by B overlaps the area occupied by A; therefore, if B occurs, there is a 75 Percent chance that A will also occur. Similarly, because P(AB) = P(BIA)P(A), P(BC) = P(C|B)P(B), and P(BC) = P(BIC)P(C), conditional probabilities P(BJA), P(CIB) and P(BIC) can be determined as follows: P(BIA)= mt P(CIB) = = = 4 = 25 Pepto) = ES) P(C) With these values determined, the fact that P(AB) = P(A|B)P(B) = P(BIA)P(A) and P(BC) = P(CIB)P(B) = P(BIC)P(C) can be demonstrated as follows: P(AB) = 3 Because P(AB) = P(A|B)P(B) = P(BIA)P(A), then P(BJA)P(A) can be substituted for P(AB), and because P(B) = P(AB) + P(BC) = P(BJA)P(A) + P(BIC)P(C), then P(BIA)P(A) + P(BIC)P(C) can be substituted for P(B). The following equation results: P(AB) _ P(BIA)P(A) PIAIE) = BB) ~ PIBIAIPIA) + PIBIO)P(O) Similarly, because P(B|C)P(C) = P(C|B)P(B) = P(BC), the conditional probability of the occurrence of event C can be derived as follows: _P(BC) _ P(BIC)P(C) PCIS)= BB) ~ BGIA)PIA) + PIBIOPIO) This formulation is Bayes’ theorem expressed in its simplest form. Bayes’ theorem can be used to revise the original probability estimates for events A and C when new informa- tion becomes available (in this case, the occurrence of event B). For this purpose, the termChapter 24 > Decision Making Under Uncertainty 24-9 on the left-hand side of the equation (P(AIB) in the first equation or P(C[B) in the second equation) is the revised estimate of the probability of the occurrence of the event of con- cem (that is, the probability that event A will occur in the first equation or that event C will occur in the second equation now that event B has occurred). This revised probability esti- mate is referred to as a posterior probability. P(A) and P(C) are the probability estimates of the occurrences of events A and C, respectively, before event B occurred. Because these estimates were made before the new information became available, they are referred to as prior probabilities. P(B|A) and P(BIC) are conditional probabilities that express the expected relationship of the new information to events A and C (that is, the probability that event B will occur and be followed by event A or C). To revise the probabilities of the occurrence of events A and C using Bayes’ theorem, multiply each prior probability by the conditional probability associated with the related event and then divide each product by the sum of all of the products. The sum of the posterior probabilities must equal the sum of the prior probabilities (P(A) + P(C) = P(AIB) + P(C|B) = 1.0). In the simple two-event world depicted by the foregoing equations, the numerator is P(BIA)P(A) for the revision of the probability of the occurrence of event A and P(BIC)P(C) for the revision of the prob- ability of the occurrence of event C. Because A and C are the only two events that can ‘occur, the denominator in both cases is the sum of these two products (P(BIA)P(A) + P(BIC)P(C)). As a result, the sum of the revised probabilities (P(AIB) + P(CIB) = 1.0) is equal to the sum of the prior probabilities (P(A) + P(C) = 1.0). ‘The use of Bayes’ theorem in the revision of probabilities can be illustrated as follows. Assume that the top management of Kotts Company is planning to introduce a new ver- sion of Kotts’ present product to expand its market share. Market surveys indicate that there is a sizable market for a less expensive version of the product and a smaller, but lucra- tive, market for a more expensive version. However, rumors are circulating that a competi- tor will introduce a new version of their product before the end of the year. The introduction of such a product by the competitor would have a material effect on the sales of Kotts Company's products. Based on familiarity with the competitor's previous actions, management assigns the following probabilities to each of the possible events: Event Description Probability A ‘No new product introduced......... i 5) B Less expensive product introduced. 2 c More expensive product introduced... rer 2 o Both a less expensive and a more expensive product introduced. . =a 1.0 Based on available data, a payoff table such as the one presented in Exhibit 24-6 can be constructed for the Kotts Company decision problem. The payoff table in Exhibit 24-6 indicates that the best course of action for Kotts Company is to introduce a more expensive product. However, before deciding on a course of action, management learns that the competitor is ing engineers (event E). Management believes that there is a .80 probability that the hiring of engineers means that the competitor is planning to manufacture and introduce a more expensive product. This means that there is a .20 probability that the competitor would hire more engineers even if it had no intention of introducing a new product (P(EJA) = .20), a .20 probability that it would hire more engineers if it were planning to introduce a new less expensive product (P(EIB) = .20), a .80 probability that it would hire more engineers if it were planning to24-10 Part 5 > Al is of Costs and Profits Kotts Company Payoff Table for Introduction of New Product Events (Actions of Competitor) A oo c D More Both Ex pense 6 me Kinds of Expected Product Prod Products Value $ on $500,000 $ 830,000 1,100,000 800,000 1,110,000 . 800,000 1,180,000 800,000 _700,000 _1.160,000 No New Kotts Company Action Product EXHIBIT 24-6 introduce a more expensive product (P(E|C) = .80), and a .80 probability that it would hire more engineers if it were planning to introduce both less and more expensive products (P(EID) = .80). Based on these newly assessed conditional probabilities, the original prob- abilities can be revised as follows, using Bayes’ theorem: P(EIA)P(A) P(EIA)P(A) + P(EIB)P(B) + P(EIC)P(C) + P(EIO)P(D) P(EIB)P(B) P(EIA)P(A) + P(EIB)P(B) + P(EIC)P(C) + S(EID)P(0) P(EIC)P(C) P(EIA)P(A) + P(EIB)P(B) + P(EIC)P(C) + P(EID)P(D) P(EID)P(O) P(EIA)P(A) + P(EIB)P(B) + P(EIC)P(C) + P(EIO)P(D) P(AIE) = P(BIE) = P(CIE) = P(DIE) = a) (2) (3) (4) Prior Probability Conditional Times —_Posterior Probability Conditional Probat of Hiring Probability (3) tine tiem £(3) total Prior Event (Action of Competitor) Probability Enter ()x(2) — +(3) total 50 A (No new product)...... 10 5/19 B (Less expensive product) 2 04 ang C (More expensive product) 80 16 e19 D (Both kinds of products) 80 08 4g x i9/g Notice that the original values in column (3) correspond to the numerators in the equa- ions that precede the table, and the column (3) total corresponds to the denominator in ‘ach equation. If more information becomes available before the decision is made, the pos- etior probabilities become prior probabilities, and the new conditional probabilities (the probabilities associated with the new information) would be used to compute new poste- rior probabilities. Also, notice that the conditional probabilities in column (2) are not totaled. Although each conditional probability must be less than 1, the sum of the condi- tional probabilities need not equal | because they do not represent a collectively exhaustive set of possibilities.Chapter 24 > Decision Making Under Uncertainty 24-11 A revised payoff table based on the revised probabilities and the original conditional values for the alternative actions being considered by Kotts Company is presented in Exhibit 24-7. The expected values of the alternatives changed when the probabilities were revised. In addition, the best course of action for Kotts Company changed from the intro- duction of a more expensive product to the introduction of a less expensive product. Kotts Company Revised Payoff Table for Introduction of New Product Event (Action of Competitor) A B c D Less More Both Expensive Expensive Kinds of Expected Kotts Company Action Product Product Product Products = Value No new product $1,000,000 $ 700,000 $ 700,000 $500,000 $ 736,842 Less expensive product... 1,300,000 800,000 1,100,000 800,000 1,057,895 More expensive product... 1,400,000 1,200,000 800,000 800,000 1,000,000 Both kinds of products... 1,500,000 __'900,000 __800,000_700,000 _973,684 Probability 5/19 29 aia ang EXHIBIT 24-7 Decision Trees Alternatives and their expected results can be portrayed graphically with a decision tree. A decision tree is a graphic representation of the decision points, the alternative actions available to the decision maker, the possible outcomes from each decision alternative along with their probabilities, and the expected values of each event. A decision tree expedites the evaluation of alternatives by giving the decision maker a visual map of the expected result of each alternative. This kind of analysis is especially useful when sequential deci- sions are involved. The use of a decision tree in a sequential-decision problem is illustrated as follows. ‘Assume that Wildcat Oil Company is faced with the problem of deciding whether or not to drill a well on a newly acquired lease. Based on historically available information, the probability of finding oil is .22, and the probability of finding no oil is .78. If oil is found, the company will gain a $1,000,000 profit; however, if oil is not found, the company will lose $300,000. Before deciding whether or not to drill, Wildcat can pay a seismographic service company $50,000 to conduct a seismic test of the proposed site. There is a .2 probability that the seismic test result will be favorable, and a .8 probability that it will not. If the results are favorable, the probability of finding oil is .7 (with a .3 probability of finding no oil); and if the results are unfavorable, the probability of finding no oil is .9 (with a .1 probability of finding oil). In this situation, Wildcat is faced with making two sequential decisions; first, whether or not to purchase a seismic test, and second, whether or not to drill. Based on the data pro- vided, a decision tree can be constructed as shown in Figure 24-2, The decision points—that is, the points at which the decision maker must choose some action—are denoted with squares. The chance points—the points at which some event related to the previous decision will occur—are denoted with circles. To determine the best2412 Part 5 > Analysis of Costs and Profits | “560,000 x 2 = $112,000 ey, ~50,000 x 8 =_~40,000 fy FIGURE 24-2 Decision Tree choice of action, the analyst first determines the expected values for the last alternatives in the sequence. Then, the expected values for the next preceding alternatives are determined, based on the assumption that the best decision alternatives for the subsequent decisions are made. This process is sometimes referred to as backward induction. The expected value of each action is written above the related chance point, and the expected value of the best choice of action is written above the related decision point.Chapter 24 > Decision Making Under Uncertainty 24-13 Notice in Wildcat’s decision tree that if a seismic test is not purchased, the expected values of drilling and not drilling are a $14,000 loss and $0 profit or loss, respectively. The best course of action, given that a seismic test is not conducted, is not to drill. On the other hand, if a seismic test is conducted, two possible results can occur. If the test result is favorable, the expected values of drilling and not drilling are a $560,000 profit and a $50,000 loss (the cost of the seismic test), respectively. If the test result is unfavorable, the expected values of drilling and not drilling are a $220,000 loss and a $50,000 loss, respec- tively. If the test result is favorable, the best course of action is to drill. If the test result is unfavorable, the best course of action is not to drill. If the best courses of action are taken, the expected value of conducting a seismic test is a $72,000 profit. Because the expected value of conducting a seismic test exceeds the expected value of no test, the seismic test should be purchased. More complex decision trees can be constructed to incorporate additional events and additional sequential decisions. For example, if several different quantities of oil can be found, several different payoffs are possible. In addition, further testing during the drilling process might decrease the uncertainty about the presence or absence of oil, thereby reduc- ing the potential loss once drilling begins. Continuous Probability Distributions In the preceding illustrations, the number of possible outcomes was small and the proba- bility distribution was discrete. However, when an outcome can taken on any value within some range, a continuous probability distribution provides a better description of the v: able and a better basis for prediction. Technically, a variable is considered continuous if, over some interval, it can take any one of infinitely many values. Examples of such vari- ables include time, weight, volume, length, and economic value; although measured in dis- crete units, these variables are continuous because they can be subdivided into infinitely small units of measure, and the number of different discrete values they can have, even without such subdivision, is very large. ‘Asa practical matter, continuous probability distributions are usually assumed to have some familiar form such as a beta, gamma, or normal distribution. This assumption makes it possible to calculate distribution parameters such as the mean or expected value and the standard deviation. The normal distribution is probably the most frequently applied continuous distribu- tion, Although it appears to approximate closely many actual business processes, the nor- mal distribution is not appropriate in all cases and should not be used indiscriminately. Its popularity probably stems from the fact that it has several convenient, attractive mathemat- ical properties. First, the normal distribution is symmetric, which means the area under the curve to the left of the median, or middle value, is a mirror image of the area to the right of the median. Second, it is unimodal, which means it has only one mode—only one most frequently occurring event. (Hecause a continuous variable can take any one of infinitely ink of the probability of an event as the probability that a vari- able will have a value that lies within some interval. An example is the probability that sales will be between $20,000 and $21,000, or, if a narrower interval is desired, the prob- ty that sales will be between $20,000 and $20,001. This is the sense in which the ‘most frequently occurring event” is used here.)Part 5 > Analysis of Costs and Profits Because the normal distribution is symmetric and unimodal, the mode is equal to the median and the mean. As a result, the value of the most likely event is the value in the middle between the two extremes, which is also the mean and the expected value of the distribution. The shape of the normal distribution can vary depending on the relative value of the standard deviation. For example, Figure 24-3 shows that the normal distribution is flatter when the standard deviation is large than when it is small. Regardless of the standard devi- ation, the fraction of total area under the curve that is contained in any interval from the mean—when the interval is measured in standard deviations—is the same for all normal distributions. In this sense the standard deviation is not only a measure of dispersion of individual observations around the mean but also a measure of distance from the mean. fron 4 < % — FIGURE 24-3 Comparison of Normal Distributions with Different Standard Deviations The total area under each of the two curves in Figure 24-3 is equal, and the area under each curve between the mean and a distance equal to one standard deviation above the mean is also equal. Because this relationship is the same for all normal curves, the portion of the total area under the curve between the mean of the distribution and any other possi- ble value can be readily determined. First, divide the difference between the mean and the value of interest by the standard deviation to obtain a standardized measure (that is, a measure of the interval between the mean and the value in terms of standard deviations). Second, use a table of areas for a standard normal distribution to find the area under the curve for the standardized measure obtained. A partial table for selected areas under the normal curve is presented in Exhibit 24-8, The use of the table of areas of the narmal distribution can be illustrated as follows. Assume that Cliff Company is considering introducing a new product. Because the prod- uct is new, the mean and standard deviation cannot be computed on the basis of historical data. Nevertheless, assume that, based on experience, management believes that the distri- bution of sales is normal, and its best guess is that 20,000 units will be sold. Because sales are believed to be normally distributed, the most likely single event is the mean (and there- fore the expected value) of the distribution, which in this case is 20,000 units. If the stan- dard deviation cannot be estimated directly, an alternative approach is'to have marketingChapter 24 > Decision Making Under Uncertainty 24-15 Selected Areas Under the Normal Curve ‘Area under ‘Area under Area under Normal Curve Normal Curve Normal Curve between u=x between vax between wand x 2 wand x o wand x. d 01994 1.05 35314 2.05 47982 e 03983 4.10 36433 2.10 48214 4 05962 1.15 37493 215 48422 3 .07926 1.20 38493 2.20 “48610 4 09871 1.25 39435 2.25 48778 30 11791 1.30 40320 2.30 48928 35 13683 1.95 41149 2.35 40 15542 1.40 41924 2.40 49180 45 17364 1.45 42647 2.45 49286 50 119146 1.50 43319 2.50 49379 55 20884 1.55 43943 2.55 49461 60 22575 1.60 ‘44520 2.60 49534 65 24215 1.65 ‘45053 265 49598 70 25804 1.70 45543 2.70 49653 75 27337 1.75 ‘45994 2.75 49702 80 28814 1.80 46407 2.80 49744 85 30234 1.85 46784 2.85 49781 90 31594 1.90 AT128 2.90 49813 95 32894 1.95 ATA 2.95 49841 1.00 (34134 2.00 ‘A7725 3.00 49865 Definitions of symbols: 1) = mean of the distribution (which is also the expected value of probability distribution) x = a value drawn from the distribution @ = standard deviation of the distribution EXHIBIT 24-8 personnel estimate a range of sales in which they have some quantifiable degree of confi- dence (for example, 50 percent or 90 percent), and then determine from the table the num- ber of standard deviations required to include an area under the normal curve equal to that degree of confidence. In this case, assume that marketing is 90 percent confident that sales will be between 12,000 and 28,000 units, which means that the 90-percent interval is 16,000 units (28,000 — 12,000 units). Next, divide the confidence level by 2, and then from the table in Exhibit 24-8 find the number of standard deviations that must be added to or subtracted from the mean to include 45 percent of the area under the curve (.90 + 2 = .45), which in this case is 1.65 standard deviations. Because 1.65 standard deviations must be added to or subtracted from the mean to include 45 percent of the area under the curve, the distance from one side of the 90 percent interval to the other is 3.3 standard deviations (1.65 x 2). Therefore, the standard deviation is determined by dividing the number of units in the 90 percent interval by the number of standard deviations required to include 90 per- cent of the area under the normal curve. The standard deviation in this case is approxi- mately 4,848 units (16,000 units + 3.3 standard deviations). Assume further that the contribution margin from the sale of one unit of the new prod- uct is $2 and that specialized machinery must be rented at a cost of $30,000 to manufacture the product. Management would like to know the probability that the company will make a profit selling the new product. In this case, the company will break even if it sells 15,00024-16 Part 5 > Analysis of Costs and Profits units ($30,000 fixed cost + $2 contribution margin per unit) and incur a loss if it sells less than 15,000 units. Therefore, the probability of making a profit will be the area under the normal curve for sales greater than 15,000 units. The distance between the mean of 20,000 units and break-even sales of 15,000 units is 1.03 standard deviations [(20,000 - 15,000) = 4,848}, which means that the area under the curve between break-even sales and the mean is approximately .35. Because half the total area under the normal curve is above the mean, the probability that Cliff Company will make a profit from the new product is .85 (an area of .35 below the mean plus an area of .50 above the mean). The reliability of the estimated probability of making a profit is highly dependent on the accuracy of the estimated mean and standard deviation and whether or not the normal curve reasonably approximates the actual distribution of the events of interest. If these estimates are based on historical data rather than subjective estimates, greater reliance can be placed on the results. If historical data are available, the estimated mean and standard deviation are ‘computed from the sample data in the same manner as demonstrated in Chapter 3. Monte Carlo Simulations Many business problems contain variables over which decision makers have little or no control. Such variables can be treated as if they were generated by a stochastic process— a process that generates events that appear to the decision maker to occur at random. If the decision problem contains many stochastic variables, it becomes complex and difficult (and perhaps in some cases impossible) to evaluate with analytical techniques. In such cases, computer simulation can be a viable alternative. The primary requirement is that the decision problem be one that can be adequately modeled with one or more mathematical ‘equations. Computer simulations that contain stochastic variables are often referred to as Monte Carlo simulations. Monte Carlo simulation uses statistical sampling techniques to obtain a probabilistic approximation of the outcome of the business system being modeled. The probability dis- tributions of the stochastic variables in the decision problem are simulated in the computer model, using a random number generator. The form of the stochastic processes simulated can be based on historical data or on estimates. The simulation is run numerous times to model the output of the business system. Based on the frequency distribution of the simu- lation results, the decision maker can determine the expected value (that is, the mean of the simulated probability distribution) and a measure of risk (that is, the variance and stan- dard deviation) for the decision problem. Monte Carlo simulations are especially useful in planning and evaluating complex new business systems. Considering Uncertainty in Capital Expenditure Evaluation ‘One way to evaluate systematically the potential effects of uncertainty on proposed capi- tal expenditures is to incorporate probabilistic estimates in the evaluation. Probabilistic estimates are most frequently used with the present value method of capital expenditure evaluation. The net present value is computed as described in Chapter 23, except that the expected value of the net cash flow in each period, rather than the single most likely net cash flow in each period, is discounted to present value. As was the case for the short-term decisions discussed earlier, the variance and the stan- dard deviation are the commonly used measures of risk. For a capital expenditure proposal,Chapter 24 > Decision Making Under Uncertainty 24-17 the variance and the standard deviation are computed for the net present value of the investment. The relative riskiness of alternative proposals can be evaluated by computing and comparing each alternative’s coefficient of variation, which for a capital expenditure proposal is determined by dividing the standard deviation of the net present value by the expected net present value. However, because capital expenditure problems encompass multiple periods, not a single period, the variance and the standard deviation of the expected net present value must be computed differently. In a multiperiod problem, cash flows from different periods must be treated as different random events; that is, the cash flow possibilities for each period form a separate distribution. As a consequence, the expected net present value for a capital expenditure proposal can be viewed as a random variable drawn from a multivariate distribution. The procedure for computing the variance and the standard deviation for the expected net present value varies, depending on whether the cash flows in each of the periods are assumed to be independent, perfectly correlated, or partially independent and partially correlated. If the cash flow in each period are independent (that is, the magnitudes of the cash flows in subsequent periods are not affected in any way by the magnitude of cash flows that occur in earlier periods), the variance of the expected net present value is computed by adding the discounted variances of the cash flows in each period.' For a two-period project, the variance of the net present value under the assumption that periodic cash flows are independent is as follows: - eo 24 2 of Variance of NPV = 063 + Toe + Ge where i is the discount rate (the weighted-average cost of capital in this case). The stan- dard deviation is as follows: 7 ‘Standard deviation of NPV = + 5+ iF A Independent cash flows can occur in practice. For example, independent cash flows could occur when the capital expenditure relates to the production of an established prod- uct or service, and the demand for that product is expected to vary in response to tempo- rary changes in consumers’ tastes and preferences or their capacity to purchase, which are uncorrelated between periods. If the cash flows are perfectly correlated (that is, the magnitude of cash flows in later periods are dependent on the magnitude of cash flows in early periods), the variance of the expected net present value is the square of the sum of the discounted periodic standard devi- ations.” For a two-period project, the variance of the expected net present value is as follows: 6 o, NPV=|o,+— +2 Variance of ot ae a aod +O 4 AO 4 2 4, 20002 200, OEP FA 141)” +P IP 'See Frederick S. Hillier, “The Derivation of Probabilistic Information for the Evaluation of Risky Investments,” ‘Management Science, Vol. 9, No. 3, pp. 443-457, i Ibid.Part 5 > Analysis of Costs and Profits The standard deviation is as follows: o | 4, ‘Standard deviation of NPV = 0, + wat wi Notice that the variance of the expected net present value under the assumption that the cash flows are perfectly correlated contains interaction terms. As a result, the variance is larger when cash flows are dependent than when they are independent. Perfectly correlated cash flows can occur if the capital expenditure relates to the pro- duction of a new product or the entrance into a new market. In such a case, consumer acceptance of the product in one period might be expected to have a direct bearing on the level of sales in the following period. If the cash flows are neither independent nor perfectly correlated, the cash flows can be treated as though they contain a mixture of independent and dependent periodic cash flows. Mathematically, this procedure is fairly simple. In such a case, the expected peri- odic cash flows are divided into two components, the independent cash flows and the per- fectly correlated cash flows. Separate periodic variances are then determined for the independent and the dependent cash flows. Once the periodic variances have been deter- mined, a separate overall variance is computed for the independent and the dependent cash flows in the manner previously described. The standard deviation of the expected net pres- ent value is then determined by taking the square root of the sum of the overall variance of the independent cash flows and the overall variance of the dependent cash flows. The difficult problem in practice is determining how much of each periodic cash flow is independent and how much is dependent. If the distribution of projected cash flows is based on a historical data set, it may be possible to determine statistically the degree of correlation in the cash flows over time. On the other hand, if the expected distribution is not based on historical data, the degree of correlation must be determined subjectively. - For illustrative purposes, assume that Tipton Company is considering the introduction of a new product called QM-30, which will require the acquisition of specialized equip- ment at a cost of $120,000. The new equipment will have an estimated useful life of 8 years with no expected salvage value. The machine qualifies as 7-year property, which means that the following tax depreciation will be available: Depreciation —_ Annual Tax Year Cost Rates Depreciation 1 $120,000 143 $ 17,160 2 120,000 245 29,400 3 120,000 175 21,000 4 120,000 125 15,000 5 120,000 089 10,680 6 120,000 089 10,680 7 120,000 089 10,680 8 120,000 045 5,400 1,000 ‘$120,000 Management's best guess is that it will be able to produce and sell 2,400 units of QM- 30 each year. The contribution margin from the sale of QM-30 will be $24 per unit. To pro- duce and distribute the new product, the company must incur $15,000 in additional fixed Sid.Chapter 24 > Decision Making Under Uncertainty 24-19 production and marketing costs each year. Although management has no historical data on which to base its estimate, the after-tax net cash inflows for each year are expected to be nor- mally distributed, which means that management's best guess estimates of the annual cash inflows are also the expected values of the annual cash inflows. The expected value of annual pretax cash inflows net of cash outflows is $42,600 [(2,400 units x $24 contribution margin) — $15,000 annual fixed cost]. Exhibit 24-9 illustrates the computation of the expected value of annual after-tax cash flows, based on an effective tax rate of 40 percent. Tipton Company Capital Expenditure Proposal for New Equipment Acquisition Estimated After-Tax Cash Flows a) @ @) (4) (5) (6) Expected Expected Expected Expected Value of Value Value of Value of Taxable ofTax —After-Tax Net Pretax Net Tex Income Liability Cash Flow Year CashFlow Depreciation (2)-(3) (4x 40% —(2)-(5) 0 $(120,000) — = — —_ $(120,000) 1 42,600 $17,160 $25,440 $10,176 32,424 2 42,600 29,400 13,200 5,280 37,320 3 42,600 21,000 21,600 8,640 33,960 4 42,600 15,000 27,600 11,040 31,560 5 42,600 10,680 31,920 12,768 29,832 8 42,600 10,680 31,920 12,768 29,832 7 42,600 10,680 31,920 12,768 29,832 8 42,600 5,400 37,200 14,880 __27,720 $132,480 EXHIBIT 24-9 In addition, management believes that the periodic standard deviation of sales will be about 800 units. As a consequence, the after-tax cash flow value of the periodic standard deviation is $11,520 [800 units x $24 contribution margin x (100% — 40% tax rate]. If Tipton’s weighted-average cost of capital is 12 percent, the expected net present value is determined as illustrated in Exhibit 24-10. Independent Cash Flows If the cash flows in each period are independent, the standard deviation of the expected net present value of $39,674 is computed by taking the square root of the sum of the discounted periodic variances. For the proposed Tipton Company capital investment, the standard devi- ation under the independent cash flow assumption is computed as shown in Exhibit 24-11. Perfectly Correlated Cash Flows If the cash flows in each of the periods are perfectly correlated with one another, the stan- dard deviation of the expected net present value is determined by summing the discounted standard deviations for each period over the life of the project. For the proposed TiptonPart 5 > Analysis of Costs and Profits Tipton Company Capital Expenditure Proposal for New Equipment Acquisition Expected Net Present Value of After-Tax Cash Flows a) @ (3) (4) Present Value | Expected Value of Expected | of After-Tax After-Tax Net Cash Present Value Net Cash Flow Year (Outflow) Inflow. of $1 at 12% (2) x (3) 0 $(120,000) 1.000 $(120,000) 1 32,424 893 28,955 2 37,320 797 29,744 3 33,960 712 24,180 4 31,560 636 20,072 5 29,832 587 16,915 6 29,832 507 15,125 7 29,832 452 13,484 e 27,720 404 11,199 Expected net present value.. ($39,674 EXHIBIT 24-10 Tipton Company Capital Expenditure Proposal for New Equipment Acquisition ‘Standard Deviation of Expected Net Present Value Independent Cash Flow Assumption a) (2) @) @ (5) ©) Present Value of Present Periodic Periodic Present = $1.at 12% Value of Standard Variance Value of Squared Variance. Year Deviation (2)Squared $1 at 12% (4) Squared (3) x (5) oO oO oO 1,000 1.000000 0 1 $11,520 $132,710,400 893 797449 $105,829,76 2 11,520 132,710,400 797 635209 84,298,840 3 11,520 192,710,400 712 506944 67,276,741 4 11,520 132,710,400 636, 404496 53,680,826 5 11,520 182,710,400 567 321489 42,664,934 6 11,520 182,710,400 507 257049 94,113,076 7 111520 192,710,400 452 204304 27,113,266, 8 11,520 182,710,400 404 “163216 __ 21,660,461 Variance of net present value. Standard deviation /ariance of net _ (e456 637,920 of net present value =| present value = V$436,637,920 = $20,896 EXHIBIT 24-11Chapter 24 > Decision Making Under Uncertainty 24-21 Company capital investment, the standard deviation of the expected net present value under the perfectly correlated cash flow assumption is illustrated in Exhibit 24-12. Notice that the standard deviation of the expected net present value when the cash flows are perfectly correlated ($57,231) is substantially larger than when the cash flows are independent ($20,896). This result is consistent with the intuitive notion that the intro- duction of established products is less risky than the introduction of new products: Tipton Company Capital Expenditure Proposal for New Equipment Acquisition Standard Deviation of Expected Net Present Value Perfectly Correlated Cash Flow Assumption a 2) @) (4) Present Value of Periodic Present Standard Standard Value of Deviation Year Deviation $1 at 12% 2)x(3) oO oO 1,000 1 $11,520 893 2 11,520 797 3 11,520 4 11,520 5 11,520 6 11,520 7 11,520 8 11,520 indard deviation of present value.. EXHIBIT 24-12 Mixed Cash Flows If the periodic cash flows are neither independent nor perfectly correlated, the cash flows can be treated as though they contain a mixture of independent and dependent periodic cash flows. The expected periodic cash flows are simply divided into two components, the independent cash flows and the perfectly correlated cash flows. A separate expected value and a separate variance are computed for the independent and the dependent cash flows in the usual way. The standard deviation of the expected net present value is then determined by taking the square root of the sum of the variance of the independent cash flows and the variance of the dependent cashflows. Assume that, of the expected annual after-tax net cash inflow for the proposed Tipton Company capital investment, 60 percent is determined to be independent and 40 percent is determined to be perfectly correlated. The expected net present value of the investment is presented in Exhibit 24-13. For simplicity, also assume that 60 percent of the periodic standard deviation of 800 units is determined to be independent and 40 percent perfectly correlated, As a conse- quence, the periodic standard deviation for the independent cash flows is $6,912 [800 units x 60% x $24 contribution margin x (100% — 40% tax rate)], and the periodic stan- dard deviation for the dependent cash flows is $4,608 [800 units x 40% x $24 contribu- tion margin x (100% ~ 40% tax rate). Computation of the variance of the net presentPart 5 > Analysis of Costs and Profits Tipton Company Capt Expenditure Proposal for New Equipment Acquisition Net Present Value of Cash Flows Mixed Cash Flow Assumption a 2) @) “ ©) 6) a) (2) PF Expected Expected Independent Dependent ‘After-Tax ‘After-Tax Present Net Cash Net Cash Value of Year Inflow Inflow Sat 12% 0 1.000 1 $19,454 $12,970 893 2 22,392 14,928 797 3 20,376 13,584 712 4 18,936 42,624 836 5 17,899 11,933 567 6 17,899 11.933 507 7 17,899 11,933 452 8 16,632 11,088 404 EXHIBIT 24-13 value of the independent cash flows is presented in Exhibit 24-14, and the variance of the net present value of the dependent cash flows is illustrated in Exhibit 24-15. The standard deviation of the expected net present value of the investment is the square root of the sum of the variances of the independent and dependent cash flows. The stan- dard deviation of the expected net present value for the Tipton Company investment is determined as follows: Variance of net present value for dependent cash flows $524,135,236 Variance of net present value for independent cash flows 157,189,651 Variance of total net present value of investment.. $681,924,887 Standard deviation of — Variance of total _ /¢e57 904,607 total net present value ~ | net present value = VS681.324,887 = $26,102 Evaluating Investment Risk ‘Once the standard deviation of the expected net present value has been determined, it can be used to evaluate the riskiness of the proposed capital investment. The coefficient of vari- ation, computed by dividing the standard deviation by the expected net present value (under the assumption of independent cash flows $20,896 + $39,674 = .527 for the pro- posed Tipton Company project), can be compared to the coefficient of variation for simi- lar projects. Alternatives with the smallest coefficients of variation are the least risky. Management may also want to know the range of the return, measured in terms of net Present value, that is likely to occur at some level of probability. As stated previously, one of the properties of the normal distribution is that areas of the normal distribution can beChapter 24 > Decision Making Under Uncertainty 24-23 Tipton Company Capital Expenditure Proposal for New Equipment Acquisition ‘Variance of Net Present Value for Independent Cash Flows Mixed Cash Flow Assumption a) (2) (3) 4) 6) ) Independent —_ Independent Present Cash Flow Cash Flow Value of Present Periodic Periodic Present $1ati2% Value of | Standard Variance Valueof Squared Variance | Year Deviation (2) Squared $1.at 12% (4) Squared (3) x (5) a ° 0 0 1.000 F 1 $6,912 $47,775,744 893 $ 38,098,719 2 6,912 (47,775,744 797 30,347,583 3 6,912 AT,T75,744 72 24,219,627 4 6.912 47,775,744 696 19,325,097 5 6,912 47,775,744 567 15,359,376 6 6,912 47,775,744 507 12,280,707 7 6,912 47,775,744 452 9,760,776 8 6,912 47,775,744 404 7,797,766 | Variance of net present value for independent cash flows... $157,189,651 l EXHIBIT 24-14 Tipton Company Capital Expenditure Proposal for New Equipment Acquisition Variance of Net Present Value for Dependent Cash Flows Mixed Cash Flow Assumption @ , @) @) 4) Dependent Present Cash Flow Value of Periodic Present Standard Value of Deviation Year Deviation $1at 12% (2) x (3) 0 0 1.000 0 1 $4,608 893 $ 4,115 2 4,608 797 3.673 3 4,808 712 3,281 4 4,608 636 21931 5 4,608 567 2613 6 4,608 507 2: 7 4,808 452 2,083 8 4,608 404 1,862 Standard deviation of net present value for dependent cash flows. $22,304 Variance of net ‘Standard deviation of |? | present value for = | net present value for} = ($22,804)? = $524,135,236 | dependent cash flows dependent cash flows L EXHIBIT 24-1524-24 Part S > Analysis of Costs and Profits related to deviations from the mean expressed in terms of standard deviations. For example, the area under the normal curve from one standard deviation below the mean to one standard deviation above the mean is about 68 percent of the total area under the curve. The area bounded by two standard deviations above and below the mean is about 95 percent, and for three standard deviations, about 99 percent. Because the sum of more than one normally dis- tributed random variable is itself a normally distributed random variable, the net present value of a multiperiod investment, for which the cash flows in each period are expected to be normally distributed, can be treated as a normally distributed random variable. Thus, for the proposed Tipton Company capital investment under the assumption of independent cash flows, there is about a 68 percent probability that the net present value will be between $18,778 ($39,674 — $20,896) and $60,570 ($39,674 + $20,896), and there is about a 95 per- cent probability that the net present value will be between —$2,1 18 [$39,674 — (2 x $20,896)] and $81,466 [$39,674 + (2 x $20,896)]. Management may also want to know the probability of achieving a net present value greater than zero. If the expected net present value is positive, the probability of actually achieving a net present value greater than zero is equal to the sum of (a) the portion of the area under the normal curve that is above the expected net present value (which is always 50 percent because the expected net present value is the mean, and the distribution is sym- metrical) and (b) the portion of the area under the curve between the expected net present value and a net present value of zero. Area (b) can be measured in standard deviations (by dividing the expected net present value by the standard deviation) and then converted to the percentage of the area under the curve by using a table of Z values for the normal dis- tribution, such as the one provided in Exhibit 24-8. For the proposed Tipton Company capital investment under the assumption of inde- pendent normally distributed cash flows, the area under the curve between the expected net present value of $39,674 and a net present value of zero is 1.8986 standard deviations [($39,674 — 0) + $20,896], which, according to the table of Z values (Exhibit 24-8), is about 47 percent of the total area under the curve. Consequently, the probability that the proposed investment will yield a positive net present value is 97 percent; that is, 47 percent (the area below the mean but above zero) plus 50 percent (the area above the mean). On the other hand, if the cash flows are expected to be perfectly correlated, the probability that the pro- posed investment will yield a positive net present value declines to about 76 percent, because the standard deviation of the expected net present value increases from $20,896 to $57,231. The area between the expected net present value of $39,674 and a net present value of zero is .6932 standard deviations [($39,674 — 0) + $57,231], which, according to the table of Z values, is about 26 percent of the area below the mean. The 26 percent of the area below the mean plus the 50 percent above the mean is equal to 76 percent. The reliability of the estimated range for the net present value and the probability of achieving a positive net present value are highly dependent on the accuracy of the esti- mates on which they are based; that is, the expected values of the annual cash flows and their estimated standard deviations. If these estimates are based on historical data rather than subjective estimates, greater reliance can be placed on the results. Incorporating Nonquantitative Factors into the Analysis Traditional economic evaluation tools are often criticized because they do not incorporate qualitative factors into the decision model. If the benefits to be derived from an expendi- ture do not result in an economically measurable value, they are ignored. Yet most of theChapter 24 > Decision Making Under Uncertainty 24-25 benefits to be derived from investments in new technologies are strategic and difficult to quantify. The multi-attribute decision model (MADM) is an expenditure evaluation tool that explicitly incorporates both quantitative and nonquantitative factors into the decision analysis. In MADM, alternative courses of action are rated on how well each performs in achieving important quantitative and nonquantitative factors. The factors are the important benefits that management expects from the investment. Each factor is assigned a weight based on its importance relative to all other factors. Total factor weights must sum to 100. When the relative importance of the factors has been determined, each alternative is rated on the basis of how well management believes it will satisfy each factor. For example, a rating of 0 can be assigned for each factor that the alternative does not satisfy, 1 for each factor that it only minimally satisfies, and 2 for each factor that it more than adequately satisfies. These performance ratings are then weighted by management's estimate of the likelihood that the alternative will achieve the level of satisfaction expected, Each factor’s relative importance weighting is multiplied by its performance rating and then again by the likelihood that it will achieve the performance expected. The results are weighted scores that are added together to arrive at a composite score for each alternative. The alternative with the highest composite score best satisfies the multiattribute objectives of management and is selected for implementation. The use of MADM in a decision problem is illustrated as follows. Assume Nicady Corporation is considering replacing one of its production facilities. One choice is to replace the facility with one that uses the same technology. Alternatively, the facility can be replaced with a computer integrated manufacturing system (CIM). The net present value and the payback methods are used to evaluate the economic value of capital expen- diture proposals. In a meeting, members of the management team identified additional nonfinancial benefits they would like to realize from the replacement. After considerable debate, the following seven factors and relative importance weightings were agreed on: Relative Importance Factor Weighting Net present value. a 30 Cc 10 Reduced customer response time. 15 Reduced inventory levels. 10 Improved product quality... 15 Improved employee morale .. 10 Improved image to customers . to Total... 100 The net present value of an investment in CIM is negative. In contrast, the net present value of an investment in existing technology is positive and about 10 percent of the initial cash outflow. In addition, the payback period is considerably shorter for an investment in existing technology than for a CIM system. If the decision is based solely on quantifiable economic measures, the preferable choice is unambiguous: replace the present facility with anew one of the same technology. However, when nonfinancial factors are considered, the best decision is not clear, Customer response time and inventory levels are expected to be substantially reduced with an investment in CIM but not affected by an investment in exist- ing technology. Both alternatives are expected to improve product quality, employee morale and the company’s image to customers, but CIM is expected to provide a greater24-26 Part 5 > Analysis of Costs and Profits improvement in product quality and image to customers. Based on this analysis of the potential benefits and management's estimation of the likelihood that these benefits will be realized, a MADM worksheet such as the one presented in Exhibit 24-16 can be con- structed. The MADM worksheet in Exhibit 24-16 indicates that the company should replace its present production facility with a CIM system because the composite score for the CIM alternative (94) is greater than the composite score for the existing technology alternative (81). In this case, the importance of the nonfinancial benefits and expected likelihood that they will be achieved weights the decision in favor of the alternative that has the weakest measures of measurable economic value. Nicady Corporation Capital Expenditure Proposal MADM Worksheet Relative Replace with Existing Technology se emince with Ne Teo Importance Performance Weighted Performa: Factors Weighing Rating’ Likelihood "Score Rating’ 30 2 8 48 0 10 2 8 16 0 response time........ 15 0 1.0 0 2 Reduce inventory levels ... sce 10 oO 1.0 0 2 Improved product quality... _ 15 1 4 6 2 bnpevel {empioyee - 10 1 6 6 1 ipnreat image to customers. 40 1 5 5 2 Total... 100 at EXHIBIT 24-16 Summary Probability analysis is an application of statistical decision theory that, under conditions of uncertainty, leads to more consistent and reliable decisions than single best guesses. Probability analysis improves decisions by incorporating the distribution of possible out- comes. Decisions are based on the expected value of an outcome rather than the single most likely outcome. In addition to an outcome’s expected value, its variance, standard deviation, and coefficient of variation can be computed and used to evaluate riskiness of alternatives. Probability estimates can be used to construct payoff tables and decision trees, which help in selecting the best decision under uncertainty. As new information becomes available, probability estimates can be revised and the quality of decisions improved. In addition to discrete probabilities, continuous probability distributions can be used in both short-term and long-term decisions. The normal distribution is especially useful in evalu- ating risk. The multi-attribute decision model is a workable approach to incorporating non- quantitative factors into a decision.Chapter 24 > Decision Making Under Uncertainty 24-27 Key Terms probability analysis (24-1) probability (24-1) expected value (24-2) conditional value (24-2) variance (24-3) standard deviation (24-3) coefficient of variation (24-3) payoff table (24-4) joint probabilities (24-7) conditional probabilities (24-7) posterior probability (24-9) prior probabilities (24-9) decision tree (24-11) Monte Carlo simulations (24-16) multi-attribute decision model (MADM) (24-25) Discussion Questions Qt Q24-2 24-3 Q74-4 Q24-5 Q24-6 Qu4-7 Q24-8 074.9 Q24-10 Q24-11 Q24-12 Why should a manager try to assess the probabilities associated with possible outcomes before making a'decision under conditions of uncertainty? Define expected value. In what way is the standard deviation of the expected value useful? What is the coefficient of variation, and how is it used in evaluating alternatives? Contrast joint probability and conditional probability. Why would management be interested in the revision of probabilities? ‘What is a decision tree and how is it used? What is the difference between a discrete probability distribution and a continuous proba- bility distribution? What are the attractive properties of the normal distribution? What is the purpose of Monte Carlo simulation? Even if cash flows are normally distributed, it is desirable to incorporate probability analy- sis into capital expenditure evaluation, Why? In what way does the computation of the variance of multiperiod cash flows differ from the variance of a single period cash flow?ah78 Part 5 > Analysis of Costs and Profits Q24-13 Ina capital budgeting context, what is meant by independent periodic cash flows and under what conditions might they be expected to occur? Q24-14 In a capital budgeting context, what is meant by perfectly correlated periodic cash flows and under what conditions might they be expected to occur? Q24-15 How might the variance of the net present value of a capital expenditure proposal be com- puted if the periodic cash flows are neither independent nor perfectly correlated? Q24-16 What is MADM, and in what way is it useful? Exercises E24-1 Expected Value and Coefficient of Variation. Tunnelston Company is considering a pro- posal to introduce a new product, XPL. An outside marketing consultant prepared the fol- lowing probability distribution describing the relative likelihood of monthly sales volume levels and related income (loss) of XPL: Monthly Sales Income Volume Probability (Loss) 3,000 05 $(35,000) 6,000 15 5 9,000 40 30,000 12,000 30 50,000 15,000 10 70,000 Required: (1) Compute the expected income or loss (expected value). (2) Compute the standard deviation and the coefficient of variation. (AICPA adapted) E24-2 Expected Value and Coefficient of Variation. In planning its budget for the coming year, the controller of the Warrenburg Corporation obtained the following data concerning sales for one of the company’s products for the most recent 60 months: Monthly Sales Volume Frequency 10,000 9 11,000 15 12,000 18 13,000 9 14,000 6 15,000 3 The contribution margin per unit for the coming month is expected to be $10. Required: (1) What is the expected value of the monthly contribution margin for the product? (2) Compute the coefficient of variation of the contribution margin from the product.Chapter 24 > Decision Making Under Uncertainty 24-29 E24-3 E24-4 E24-5 Make-or-Buy Decision Under Uncertainty. Quentin Company manufactures a thermo- stat designed for effective climactic control of large buildings. The thermostat requires a specialized thermocoupler, purchased from Cosmic Company at $15 each. For the past two years, an average of 10% of the purchased thermocouplers have not met quality require- ments; however, the rejection rate is within the range agreed on in the purchase contract. ‘The company has most of the facilities and equipment needed to produce the compo- nents. Additional annual fixed cost of only $32,500 would be required. The Engineering Department has designed a manufacturing system that would hold the defective rate to 4%. At an annual demand level of 18,000 units, engineering estimates of the probabilities of sev- eral variable manufacturing unit costs, including allowance for defective units are as follow: Estimated Variable Cost per Unit Probability, = peor Required: Prepare a make-or-buy decision analysis using the probability distribution estimates. (ICMA adapted) Payoff Table. Jessica Company buys and resells a perishable product. A large purchase at the beginning of each month provides a lower per unit cost and assures that Jessica can purchase all the items it wishes. However, unsold units at the end of each month are worth- less and must be discarded. If an inadequate quantity is purchased, additional units of acceptable quality are not available. The units, which Jessica sells for $1.25 each, are purchased at a fixed fee of $50,000 per month plus $.50 each, if at least 100,000 units are ordered and if they are ordered at the beginning of the month. The needs of Jessica's customers limit the possible sales volumes to only four quanti- ties per month—100,000, 120,000, 140,000, or 180,000 units. However, the total quantity needed for a given month cannot be determined prior to the date Jessica must make its pur- chases. The sales managers are willing to place a probability estimate on each of the four possible sales volumes each month. They noted that the probabilities for the four sales vol- umes change from month to month because of the seasonal nature of the customers’ busi- nesses. Their probability estimates for December, 20A, sales quantities are 10% for 100,000, 30% for 120,000, 40% for 140,000, and 20% for 180,000. Required: Prepare a payoff table showing the expected value of each of the four possible strategies of ordering units, assuming that only the four quantities specified are ever sold and that the occurrences are random events. Identify the best strategy. (ICMA adapted) Payoff Table and the Expected Value of Perfect Information. Wurst Inc. operates the concession stands at the State College football stadium. State College has had successful football teams for many years and, as a result, the stadium is virtually always filled. From time to time the company has found its supply of hot dogs inadequate, while at other timesE24-6 Part 5 > Analysis of Costs and Profits there has been a surplus. A review of sales records for the past 10 seasons reveals the fol- lowing frequency of hot dogs sold: Quantity of Hot Dogs Number of Sold Games 40,000 5 20,000 10 30,000 20 40,000 15 Total 50 Hot dogs that sell for $.50 each cost $.30 each. Unsold hot dogs are donated to the local orphanage. Required: (1) Prepare a payoff table depicting the expected value of each of the four possible strategies of ordering 10,000, 20,000, 30,000, or 40,000 hot dogs, assuming that the four quantities listed were the only quantities ever sold and that the occurrences were random events. (2) Compute the dollar value of knowing in advance what the sales level would be at each game (that is, the expected value of perfect information). (ICMA adapted) Revision of Probabilities. Sessionville Manufacturing Company plans to introduce a new product known as Quintex. Based on experience and contacts with customers, the vice- President of marketing believes that the demand for Quintex will be between 30,000 and 60,000 units. The following probabilities have been assigned to each possible level of demand: Demand Probability 30,000 10 40,000 10 50,000 50 60,000 30 Before beginning production, the president of the company asked the vice-president of marketing to have the market demand analyzed by an expert system computer program available from a local marketing service company. The program is a market demand analy- sis model built on the basis of decisions made by several successful experts in the field of market demand analysis. Although the mode! may overlook some factors unique to the market for Quintex, it captures many important variables and has generally been found to be useful in forecasting product demand. The vice-president complied with the president's Tequest, and the results of the expert system analysis follow: Demand Probability 30,000 20 40,000 50 50,000 20 60,000 10 Required: Using Bayes’ theorem, compute the posterior probabilities for the various lev- els of demand for Quintex, assuming that the demand probabilities generated by the expertChapter 24 > Decision Making Under Uncertainty 24-31 E24-7 E24-8 E249 system provide ditional probabil »w information (that is, assume the expert system probabilities are con- ). Decision Tree. The manager of MusicKing Company is trying to decide whether to move his store to the new Market Shopping Mall or to keep it in its present location. Because of changing economic conditions, the market for stereo equipment may decline, remain the same, or increase during the coming year. The manager estimates the move to Market Shopping Mall will cost $10,000. In addition, the manager assesses market conditions and the associated net profits for the next year under both alternatives (excluding the cost of the move) to be as follows: Net Profits Expected Move to Do not ‘State of Market Probability Mall Move 1 2 $(25,000) $(10,000) 5 50,000 ‘40,000 3 100,000 80,000 Required: Construct a decision tree for the manager's problem, and calculate the expected value for each alternative. Should the manager choose to move or not? CGA-Canada (adapted). Reprint with permission. Decision Tree. A firm producing stereo amplifiers can manufacture a subassembly or pur- chase it from another company. Anticipated profits for each alternative, make or buy, and for three different levels of demand for the stereo amplifier are as follows: Expected Net Profits State of Market Probability Make Buy High 4 Fz 4 $50,000 $35,000 Medium 3 30,000 30,000 Low.. 3 (10,000) 5,000 Required: Construct a decision tree for the make-or-buy decision, and calculate the expected value for each alternative. Indicate whether the firm should make or buy. CGA-Canada (adapted). Reprint with permission. Decision Tree. A land developer needs to decide which of two parcels of land to bid on for development. The developer assesses the chance of success on bids to be 60% for par- cel A and 80% for parcel B. Development of either parcel will take two years, after which time parcel A is expected to generate a profit of $200,000, and parcel B is expected to gen- crate a profit of $100,000. However, if the area in which parcel B is located can be rezoned, this parcel could generate a $300,000 profit. Costs of $10,000 would be incurred in prepar- ing and presenting the case for rezoning to the review board, The developer assesses the probability of a successful appeal for rezoning at 50%. An appeal for rezoning would not be undertaken unless parcel B were successfully acquired by bid. Required: Construct the decision tree for the land developer's problem, and calculate the expected profits for each alternative. On which parcel should the developer place a bid? Should the developer apply for rezoning? CGA-Canada (adapted), Reprint with permission.24-32, E24-10 E24-11 E24-12 E24-13 E%4-14 Part § > Analysis of Costs and Profits Break-Even Analysis. Titusberry Inc. is considering the introduction of a new product. Based on past experience, management believes that the distribution of sales demand is normal. Management's best guess is that the company will be able to sell 50,000 units of the new product in the first year, and management is 50% confident that first-year sales will be between 45,000 and 55,000 units. The contribution margin from the sale of each unit is $5. Special machinery must be rented at an annual cost of $193,750 to manufacture the new product. Required: (1) Determine the expected standard deviation. (The interval between the mean and x that includes 25% of the area under the normal curve is .667 standard deviations.) (2) What is the probability that the company will make a profit on the sale of the new product? Round the answer to the nearest whole percent. Expected Net Present Value of Investment with Normally Distributed Cash Flows. Randall Enterprises is considering a capital expenditure proposal that will cost $20,000 and yield an expected after-tax cash inflow of $5,000 each year for 6 years. There is no expected salvage value at the end of the life of the project. The after-tax net cash inflows for each year are expected to be normally distributed with a standard deviation of $800. The company's weighted-average cost of capital is 10%. Required: Compute the expected net present value of the capital expenditure proposal. Standard Deviation of Expected Net Present Value when Periodic Cash Flows Are Normally Distributed and Independent. Butlersville Company is considering a capital proposal that has an expected net present value of $3,000. The periodic cash inflows are normally distributed with a standard deviation of $500 each period. The initial cash out- flow has a zero standard deviation. The company’s weighted-average cost of capital is 12%, and the capital project has an expected life of 8 years. The periodic cash inflows are expected to be independent of one another. Required: Compute the standard deviation of the expected net present value of the invest- ment. Standard Deviation of Expected Net Present Value when Periodic Cash Flows Are Normally Distributed and Dependent. Ramos Company is considering a capital expen- diture for which the periodic cash inflows are expected to be normally distributed and per- fectly correlated. The expected net present value of the proposed project is $5,000, and the standard deviation of the cash inflows is $1,000 in each period. The initial cash outflow has a zero standard deviation. The company's weighted-average cost of capital is 10%, and capital project is expected to have a life of 5 years. Required: Compute the standard deviation of the expected net present value for the Ramos Company investment. Standard Deviation of Expected Net Present Value when Periodic Cash Flows Are Neither Independent nor Perfectly Correlated. Columbia Corporation is considering an investment in new machinery with a 7-year estimated useful life and an estimated net pres- ent value of $12,000. The cash inflows are expected to be normally distributed; however,Chapter 24 > Decision Making Under Uncertainty 24-33 60% of each period’s cash inflow is expected to be independent, and the remaining 40% is expected to be perfectly correlated. Cash inflows are expected to be $10,000 each period. The periodic independent cash inflows have a standard deviation of $1,000, and the periodic dependent cash inflows have a standard deviation of $1,500. The initial cash outflow has a standard deviation of zero. The corporation's weighted-average cost of capital is 12%. Required: Compute the standard deviation of the expected net present value. E24-15 Evaluating Capital Project Risk. Mayer Company is considering investing in a new plant that will produce a product for which there is an established market. Demand for the product historically has followed a random normal distribution and has been independent from one period to the next. Management has determined that the expected net present value of the investment is $30,000, and the standard deviation of the expected net present value is $25,000. Required: (1) Determine the 95% confidence interval for the net present value, that is, the range within which the net present value of the proposed investment will fall about 95% of the time. (2) Using the table of selected areas under the normal curve in Exhibit 24-8, determine the probability that the net present value of the proposed investment will exceed zero. Problems P24-1 Introduction of New Product. Berry Company is a manufacturer of precision sensing equipment. J. Adams, a project engineer, has developed a prototype of an automatic test- ing kit that continually evaluates water quality and chemical content in hot tubs. Adams believes the kit will permit domestic tub owners to control water quality better at reduced costs and with less time invested. Management is convinced the kit will have strong mar- ket acceptance. The new equipment uses the same technology that the company uses on other equipment, so existing facilities can be used to produce the product. ‘Adams, who is ready to proceed with developing cost and profit plans for the testing kit, asked the Marketing Department to develop a suggested selling price and estimate the sales volume. The Marketing Department contracted with Statico, a marketing research company, to develop price and volume estimates. Based on an analysis of the market, Statico considered unit prices between $80 and $120. Within this price range, it recommended a price of $100 per kit. The frequency dis- tribution of expected unit sales volume at this selling price is as follows: Annual Unit Sales Volume Probability 50,000 25 60,000 45 70,000 20 80,000 10 in The Profit Planning Department accumulated cost data that Adams had requested. The new product will require direct materials costing $25 per unit and will require 2 hours of direct labor to manufacture. The company is currently in contract negotiations with its