Big Picture C

Week 6-7: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to:
a. Apply commonly used techniques in assessing investment under
uncertainty.
b. Explain the impact of the firm’s degree of operating and financial leverage
in making investment decisions.

Big Picture in Focus: ULOa. Apply commonly used techniques in

assessing investment under uncertainty.

Metalanguage
For you to demonstrate ULOa, you will need operational understanding of the terms
enumerated below.
1. Risk Management is the process of measuring or assessing risk and
developing strategies to manage it.

2. Decision Making under Certainty means that for every decision to make
there is only one event and therefore only a single outcome for each action.

3. Decision Making under Uncertainty involves several events for each action
with its probability of occurrence.

4. Probability provides a method for mathematically expressing doubt or

assurance about the occurrence of a chance event.

5. Payoff (decision) tables are helpful tools for identifying the best solution given
several decision choices and future conditions that involve risk.

6. Perfect information is the knowledge that a future state of nature will occur
with certainty, being sure of what will occur in the future.

7. Sensitivity analysis describes how sensitive the linear programming optimal

solution is to a change in any one number.

8. Simulation is a technique for experimenting with logical and mathematical

models using a computer.

9. 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.
Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the 6th and 7th
weeks of the course, you need to fully understand the following essential
knowledge laid down in the succeeding pages. Please note that you are not limited
to exclusively refer to these resources. Thus, you are expected to utilize other
books, research articles and other resources that are available in the university’s
library e.g. ebrary, search.proquest.com etc., and even online tutorial websites.
1. Risk Management is the process of measuring or assessing risk and developing
strategies to manage it. It is a systematic approach in identifying, analyzing and
controlling areas with a potential for causing unwanted change.

According to the International Organization of Standardization (ISO 3100), risk

management is the identification, assessment and prioritization of risks followed by
a coordinated and economical application of resources to minimize, monitor and
control the probability and/or impact of unfortunate events and to maximize the
realization of opportunities.

ISO identifies the basic principles of risk management and that risk management
should:
1. Create value
2. Address uncertainty and assumptions
3. Be an integral part of the organizational processes and decision-making
4. Be dynamic, iterative, transparent, tailorable, and responsive to change
5. Create capability for continuous improvement
6. Be systematic, structured, and continually or periodically reassessed.

2. Risk Management Process. According to ISO, the risk management process

has the following steps:
1. Establishing the context. This involves identification of risks; planning the
risk management process; mapping out the social scope, identity and
objectives of stakeholders and basis upon risk will be evaluated; establishing
a framework; and developing risks analysis and mitigation or solution of
risks.
2. Identification of potential risks. This begins with the analysis of the source
of problem or the problem itself.
3. Risk assessment. After identifying the risk, the next thing to do is to
evaluate the potential severity of impact and the probability of occurrence of
the risk.

3. Elements of Risk Management. Ideal risk management should minimize

spending of manpower or other resources and the same time minimizing the effect
of risks. The performance of assessment methods should include the following
elements:
1. Identification, characterization and assessment of threats.
2. Assessment of the vulnerability of critical assets to specific threats
3. Determination of the risk
4. Identification of ways to reduce identified risks
5. Prioritization of risk reduction measures based on a strategy
4. Potential Risk Treatments. As suggested in ISO 3100, once risks have been
identified and assessed, techniques to manage them should be applied. The
following are the four categories of risk:

1. Risk Avoidance. This includes performing an activity that could carry risk.
However, avoiding risks would also mean losing the opportunity to earn that
accepting (retaining) the risk may have allowed.

2. Risk Reduction. This is also referred as risk optimization which involves

reducing the severity of loss or the likelihood of the loss from occurring.

3. Risk Sharing. This means sharing with another party the burden of loss or
the benefit of gain and the measures to reduce a risk.

4. Risk Retention. This involves accepting the loss or benefit of gain from a risk
when it occurs.

5. Investment Risks. The required return of an investment increases as the risk of

the investment increases. An investor would probably require risk premium as
compensation for taking the uncertainty associated with the investment. Some of
the factors that contribute to the investment uncertainty are the following:

1. Business risk. This refers to the uncertainty about the rate of return caused
by the nature of the business.
2. Financial risk. This is determined by the firm’s capital structure or sources
of financing.
3. Liquidity risk. This is associated with the uncertainty created by the inability
to sell the investment quickly for cash.
4. Default risk. This is related to the probability that some or all of the initial
investment will not be returned.
5. Interest rate risk. This is the risk that fluctuations in interest rates will cause
fluctuations to the value of the investment.
6. Management risk. This is the risk associated with the decisions made the
management and board of directors of the firms.
7. Purchasing power risk. This is the risk that the value of the return from
investment has declined as a result of inflation.

6. The most used Techniques and Models in assessing investment

alternatives under risk or uncertainty are as follows:

1. Probability
2. Value of Information
3. Sensitivity Analysis
4. Simulation
5. Decision Tree
6. Standard deviation and Coefficient of Variation
7. Project Beta
Probability
 Decision Making under Certainty means that for every decision to make there
is only one event and therefore only a single outcome for each action. There is
100% chance of occurrence; hence, the probability is 1.0.

Decision Making under Uncertainty involves several events for each action
with its probability of occurrence. The probability of occurrence maybe known to
the decision maker because of mathematical proofs and historical evidence;
otherwise, the decision maker may resort to subjective assignment of
probabilities.

Pay-off is the value assigned to different outcomes from a decision which may
be positive or negative. Information is deemed to meet the cost-benefit test if the
expected value of a decision increases as a result of obtaining additional
information. The process in deciding whether the cost-benefit criterion has been
met is called information economics.

Assigning Probabilities. Decision makers must assign probabilities to the

various outcomes that represent the likelihood of their occurrence. A probability
distribution describes the chance or likelihood of each of the collectively
exhaustive and mutually exclusive set of events. Probability provides a method
for mathematically expressing doubt or assurance about the occurrence of a
chance event. The probability of an event varies from 0 to 1.

• A probability of 0 means that the event cannot occur, whereas a probability

of 1 means that event is certain to occur.
• A probability between 0 and 1 indicates the likelihood of the event’s
occurrence.

Basic terms used with probability

1. Mutually exclusive. This is the case when two events cannot occur
simultaneously.
2. Joint probability. This is the probability that the two events will both occur.
3. Conditional probability. This is the probability that one will occur given that
the other has already occurred.
4. Independent. This means that the occurrence of one has no effect on the
probability of the other.

Illustrative problem. 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 cost of P4,000,000.
The products have the same selling price of P1,000 and the same variable costs
per unit of 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 which product should be chosen, assuming

the objective is to maximize the expected operating income.

Solution:
❖ Using the given probability distribution, determine the expected
demand for the two products:

❖ After determining the expected demand of each product, the expected

operating income should be computed:

Based on the computations presented, Product B should be chosen

because its expected income is higher by P100,000 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. It presents the
outcomes (payoffs) of specific decisions when certain states of nature (events not
within the control of the decision maker) occur.

Illustration. 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:

The payoff table can be interpreted as follows: If the dealer decides not to order
yacht, it means that regardless of the actual demand, he will not incur any gain or
loss. However, he misses an opportunity to earn in case there will be actual
demand. If the dealer decides to order 1 yacht and there is no actual demand, he
will be incurring a carrying cost of P50,000 and will report a loss of the same
amount. However, if there will be 1 actual demand, he will earn P200,000. Also, if
there will be 2 actual demands of yacht, the dealer would still be earning P200,000.
Lastly, if the dealer decides to order 2 yachts and there will be no actual demand,
the dealer will be incurring carrying cost of P50,000 for each yacht. Hence, he will
be reporting a loss of P100,000. If there is an actual demand for 1 yacht, the dealer
will earn P200,000; however it will also incur P50,000 for the carrying cost of unsold
yacht. Hence, he will have net earnings of P150,000. Lastly, if the actual demand
for yacht is 2 then the dealer will maximize his earnings to P400,000.

Assuming the probabilities of the season’s demand are as follows:

Demand Probability
0 0.10
1 0.50
2 0.40

The expected value (EV) of each decision can be computed as follows:

Order 0 Order 1 Order 2

0.1 x 0 = 0 0.1 x P(50,000) = ( P5,000) 0.1 x P(100,00) = P(10,000)
0.5 x 0 = 0 0.5 x 200,000 = 100,000 0.5 x 150,000 = 75,000
0.4 x 0= 0 0.4 x 200,000 = 80,000 0.4 x 400,000 = 160,000
EV = 0 EV = P175,000 EV = P225,000

If the decision will be based on expected value, the dealer should order 2 yachts
since it has the greatest expected value.
Expected Value of Perfect Information

Based on the previous illustrations, management can decide under uncertainty

using the expected value. The alternative that has higher expected value should be
chosen if management wants to maximize its earnings potential. However, there
are times wherein the management or owners do not want to be exposed to risk
and wish to decide only when they are already certain of the conditions at hand. In
this case, the management may decide to hire market analysts to obtain additional
information on the environmental situation; hence, trying to find a perfect
information.

Perfect information is the knowledge that a future state of nature will occur with
certainty, being sure of what will occur in the future. Before deciding to obtain the
perfect information, the management should consider how much is the expected
value of perfect information (EVPI) which can be computed as follows:

EVPI = EV without PI – Expected Value of Return for best action to take with PI

The expected value of perfect information represents that amount the company is
willing to pay to the market analysts’ error-free advice. The company should
evaluate whether it is worthy to obtain perfect information and they will just pursue
marketing research if the amount they will spend in it is less than the benefits that
they will get if they will have perfect information. However, it should be noted that
“perfect information” is not perfect in the sense of absolute predictions.

Illustration. Using the information of the yacht dealer, assume that he was able to
poll all potential customers and they truthfully stated that whether they would
purchase a yacht this year, what is the greatest money that the dealer should pay
for this information? What is EVPI?

EVPI can be computed as follows:

1. Based on the payoff table, compute the expected value of the best choice
under each state of nature.
Best Action Expected Value
Pr State of Nature Best Action Pay-off (Pr x Pay-off)
0.1 Demand =0 Buy =0 P 0 P 0
0.5 Demand =1 Buy =1 200,000 100,000
0.4 Demand =2 Buy =2 400,000 160,000
EV of the best choice = P260,000

Hence, with perfect information about future demand, the dealer expects to
make P260,000. While the choice with best expected value under uncertainty is
P225,000 as previously computed.

2. The expected value of perfect information (EVPI) can then be computed as

follows:
 Expected value with perfect information P260,000
Less: Expected value of the best choice (under uncertainty) 225,000
Expected value of perfect information (EVPI) P 35,000

This means that the dealer will NOT pay more than P35,000 to obtain
information about future demand because it will be more profitable to make the
expected value choice than to pay more to obtain the perfect information.

Sensitivity Analysis

Sensitivity analysis describes how sensitive the linear programming optimal solution
is to a change in any one number. It answers what-if questions about the effect of
change in prices or variable costs; changes in value; addition or deletion of
constraints, such as available machine hours; and changes in industrial coefficients,
such as the labor-hours required in manufacturing in a specific unit.

A trial and error method may be adopted in which sensitivity of the solution to
changes in any given variable, parameter or other assumption is calculated. 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.

Simulation

Simulation is a technique for experimenting with logical and mathematical models

using a computer. It involves experimentation that is an organized trial and error
using a model of the real world to obtain information prior to full implementation.
Models can be classified as:

a. Physical models include automobile mockups, airplane models used for

wind-tunnel tests and breadboard models of electronic circuit
b. Abstract models may be pictorial (architectural plans), verbal (a proposed
procedure), or a logical-mathematical.

Five steps in simulation procedure are as follows:

1. Define the objectives
2. Formulate the model
3. Validate the model
4. Design the experiment
5. Conduct the simulation

SIMULATION
Advantages Limitations
1. Time can be compressed. 1. Simulation model can be costly to
2. Alternative policies can be explored. develop.
3. Complex system can be analyzed. 2. Risk of error.
Decision Tree

A 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. It is a diagram that shows the
several decisions or acts and the possible consequences called events of each act.
In a more elaborate form, the probabilities and the revenue and costs of each
event’s outcome are estimated and these are combined to give an expected value
for the event.

DECISION TREE ANALYSIS

Advantages
1. An effective means of presenting the
relevant information needed in an
investment problem.
2. Combination of action choices with
different events or results of action that
chance or other uncontrollable
circumstances partially affect can be
better presented and studied.
3. The interactions of the impact of the
future events, decision alternatives,
uncertain events and their possible
payoffs can be shown with greater ease
and clarity.
4. Data are presented in a manner that
enables systematic analysis and better
decisions.
Limitations
1. It does not give management the
answers to investment problem.
2. It does not identify all the possible
events or does it list all the decisions
must be made on a subject under
analysis.
3. The interactions of such decision with
the objective of other parts of the
business organization would be too
complicated to compute manually.
4. It treats uncertain alternatives as if
they were discrete well-defined
possibilities when uncertain situations
depend on several variables subject to
such chance influences.

Self-Help: You can also refer to the sources below to help you
further understand the lesson.

Cabrera, M. B. (2015). Financial management principles and applications volume 2.

Manila: GIC Enterprises & Co., Inc.

Saunders, A., & Cornett, M. M. (2019). Financial markets and institutions (7th ed.).
New York: McGraw Hill Education.
Let’s Check

Activity 1: Multiple Choice. Write the letter of your choice in the space provided
before the number.

_______ 1. The risk that securities cannot sold at a reasonable price on short
notice is called
a. Default risk c. Purchasing-power risk
b. Interest rate risk d. Liquidity risk
_______ 2. The type of risk that is not diversifiable and affects the value of a
portfolio
a. Purchasing-power risk c. Non-market risk
b. Market risk d. Interest rate risk
_______ 3. Which of the following are components of interest rate risk?
a. Purchasing-power risk and default risk
b. Price risk and market risk
c. Portfolio risk and reinvestment-rate risk
d. Price risk and reinvestment-rate risk
_______ 4. This is a helpful tool for identifying the best solution given several
decision choices and future conditions that involve risk.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation
_______ 5. This is a technique for experimenting with logical and mathematical
models using a computer.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation
_______ 6. This describes how sensitive the linear programming optimal solution to
a change in any one number.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation
_______ 7. This is an analytical tool used in a problem in which a series of decision
has to be mage at various time intervals.
a. Sensitivity analysis c. Payoff table
b. Decision tree analysis d. Simulation

_______ 8. The amount that an investor is willing to pay to reduce if not eliminate
uncertainty.
a. Payoff c. Expected value of perfect information
b. Fixed cost d. Expected value of net investment
_______ 9. This describes the chance or likelihood of each of the collectively
exhaustive and mutually exclusive set of events.
a. Expected value c. Payoff
b. Probability d. Probability distribution
_______ 10. Two events that cannot occur simultaneously
a. Joint Probability c. Conditional probability
b. Mutually exclusive d. Independent
Let’s Analyze
Activity 1. Read and answer the problems.

Problem 1. 3K Company is considering the introduction of a new product. The

anticipated demand, probability of demand and profits for each are given below.

Product X Product Y
Product Probability of Profit Product Probability of Profit
Demand Demand (Peso) Demand Demand (Peso)
(units) % %

50,000 20 -8,000 30,000 15 -12,000

60,000 10 -5,000 40,000 15 -10,000
70,000 30 11,000 50,000 40 14,000
80,000 20 14,000 60,000 20 16,000
90,000 20 17,000 70,000 10 16,000

Required:

10. Compute the expected value of the profits of Product X and Product Y.

Product X Product Y

11. Based on the computation, which product would you choose to pursue?

_____________________________________________________________

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Problem 2. A beverage stand can sell either soft drinks or coffee on any given day.
If the stand sells soft drinks and the weather is hot, it will make P2,500; if the
weather is cold, the profit will be P1,000. If the stand sells coffee and the weather
is hot, it will make P1,900; if the weather is cold, the profit will be P2,000. The
probability of cold weather on a given day at this time is 60%.

Required:

2.1 Compute for the expected payoff for selling coffee.

2.2 Compute for the expected payoff if the vendor has perfect information.

2.3 Compute for the expected value of perfect information.

2.4 What advise can you give to the beverage stand owner, if somebody offered him
to do research and obtain the perfect information at a cost of P1,000?

In a Nutshell

Based on the concepts presented, write the three remarkable lessons you learned
in this section.

1. _____________________________________________________________
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2. _____________________________________________________________
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3. _____________________________________________________________
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Q&A List

Do you have any question for clarification? Write them here.

Questions/Issues Answers

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3.

4.

5.

Keyword Index

Decision tree Probability

Decisions under certainty Sensitivity analysis
Decisions under uncertainty Simulation
Pay-off table Risk management
Perfect information