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Uncertainty and Capital Budgeting ACCT 7320, 12/8/09, Bailey

Uncertainty and Capital Budgeting ACCT 7320, 12/8/09, Bailey. This presentation contains two parts: A general model of decision-making under uncertainty, using “expected value”

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Uncertainty and Capital Budgeting ACCT 7320, 12/8/09, Bailey

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  1. Uncertainty and Capital BudgetingACCT 7320, 12/8/09, Bailey • This presentation contains two parts: • A general model of decision-making under uncertainty, using “expected value” • Discussion of “Using Decision Trees to Manage Capital Budgeting Risk,” J. Bailes & J. Nielsen, Management Accounting Quarterly, Winter 2001

  2. Decision Models and Uncertainty • Managers frequently must deal with uncertainty. • The model presented here represents a rational approach to decision making under uncertainty, assuming you are risk-neutral.

  3. Decision Model Assumptions • Choice Criterion • Set of Alternatives (Actions to consider) Mutually exclusive, Exhaustive • Set of Events (States of Nature) • Set of Probabilities associated with the events • Set of Outcomes (Income, cost, etc., to minimize or maximize)

  4. Example of DM under Uncertainty Action Taken Buy new Eqpt Keep old Eqpt E Get Govt Income = Income = v Contract $500,000 $300,000 e n Not get Govt Income = Income = t Contract $10,000 $200,000 • Which action is best? Depends on probabilities we assign to the events.

  5. Decision Models and Uncertainty • EV=Σ(Outcomei) (Pi) i.e., summation of each outcome (in this case, income) times the probability of that outcome. • Suppose P(getting contract) = .20 [read as “probability of getting contract = .20”] • Thus P(not getting contract) = .80. • EV(buying new Eqpt) = $500,000*.20 + $10,000*.80 = $108,000 EV(keeping old Eqpt) = $300,000*.20 + $200,000*.80 = $220,000 • To maximize expected value, we keep old equipment.

  6. Forest Product Companies and Timberland • Long-term capital-budgeting decisions • More risk • Time value of money especially important • Typical decision: • Buy timberland now, or • Buy timber as needed

  7. The basic decision Starting point in hypothetical case assumes indifference given the current regulatory environment, for simplicity only.

  8. Uncertainty: Regulatory environment may change Management’s estimates.

  9. Possible Regulatory Environments and Related Outcomes $6.5-7.0 $6-4.5

  10. Expected Values of the Two Actions

  11. The End

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