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Wrapping up decision making An introduction to risk

Learn how to evaluate risks, costs, and opportunities for profit maximization in business decision-making. Understand concepts like opportunity cost, inflation, and real versus nominal interest rates.

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Wrapping up decision making An introduction to risk

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  1. “You must risque to win” --- Andrew Jackson 7th US president Nicknames: King Mob, Old Hickory, The Hero of New Orleans Wrapping up decision makingAn introduction to risk More on costs Spillovers Introducing the housing bubble What is risk? Applications of risk

  2. Extra office hours/review sessions before Test 1 • This information will be posted on GauchoSpace • Review sessions will go over an old test • Current quarter review sessions • TBA

  3. Cost allocation • For profit maximizing purposes, we will allocate costs to a project if the cost is needed to complete the project • Note that other parts of the company can sometimes benefit, however • We will incorporate these benefits into the calculation • Example: Adding a computing system to a building also requires AC

  4. Opportunity cost • Another issue that needs to be taken into account when investing is opportunity cost • Anytime an investment means forgoing other revenue, this is an added cost • Opportunity cost • Example: 10 hours per week for work • Building widgets, which sell for $1 each • Working at an I.V. coffee shop for $10/hr.

  5. Widget production function

  6. How many widgets should I build? • You should build widgets for 3 hours/week, earning $39 from widgets • You should work 7 hours/week, earning $70 from work • Total earnings: $109/week • Marginal analysis  Maximize earnings

  7. Side effects in business • Erosion • A new product or service introduced leads to a reduction in sales of products or services already on the market • Synergy • A new product or service introduced leads to an increase in sales of products or services already on the market

  8. Examples • RAZR • Erosion of other clubs • More golf ball sales • Should we develop the RAZR? • A tennis racquet breakthrough • Erosion of other racquet models • More tennis ball sales

  9. Golf = $$$ • R&D costs for the RAZR • $5 million in year 0 • Projected NPV of direct profits from the RAZR • $20 million • Projected loss of profits (in NPV) from lost sales of other clubs • $16 million • Projected increase in golf ball profits (in NPV) • $4 million • Invest: $24M in benefits > $21M in costs What if there are past sunk costs?

  10. Inflation • How does inflation affect the tools we have used to date? • So far, we have made decisions in the absence of factoring inflation in • What do we need to do to account for inflation? • The nominal interest rate is how much you are quoted to earn • Example: You are quoted a yearly interest rate of 12% • The real interest rate discounts the nominal interest rate by the inflation rate

  11. Nominal versus realinterest rates • Suppose that a bag of chips sells for $1 today and goes up by the rate of inflation each year • Assume that inflation is 5% per year in this example • $100 buys you 100 bags of chips this year

  12. Nominal versus realinterest rates • Let’s see how many bags of chips we can buy if we invest our $100 for one year • $100  $112 in one year • Price of chips goes from $1  $1.05 • $112/$1.05 = 106.67 • Real interest rate is 6.67% • Your real dollar amount goes from $100 to $106.67 in one year

  13. Calculating the real interest rate, in general • Inflation erodes our nominal interest rate in the sense that our purchasing power only goes up by the amount of the real interest rate • How much is the real interest rate? • Real interest rate = 1 + Nominal interest rate– 1, or 1 + Inflation rate • 1 + Nominal interest rate = (1 + Real interest rate)  (1 + inflation rate) Alternate approximation: Additive effect

  14. How should we discount? • Whether or not you account for inflation, you need to make sure you are consistent in your calculations • Use ALL nominal cash flows OR Use ALL real cash flows • Once you decide, you must be consistent on your method of choice • Example…

  15. Amelia’s Plumbing • Amelia starts her own plumbing company today (year 0) • Her expected cash flow (nominal terms) • Year 0: – $30,000 • Year 1: $120,000 • Year 2: $150,000 • Year 3: $160,000 • Nominal discount rate: 13% • Rate of inflation: 4% • Real discount rate: 1.13/1.04 – 1 = 8.6538%

  16. Nominal cash flow: NPV • Discounted cash flows (in $1000s) • Year 0: –30 (no discounting) • Year 1: 120 / 1.13 = 106.19 • Year 2: 150 / 1.132 = 117.47 • Year 3: 160 / 1.133 = 110.89 • Total net cash flow (in $1000s) • 304.55

  17. Real cash flows Year 0: –30 (no discounting) Year 1: 120 / 1.04 = 115.38 Year 2: 150 / 1.042 = 138.68 Year 3: 160 / 1.043 = 142.24 Discounted cash flows (note that real discount rate is 8.6538%) Year 0: –30 (no discounting) Year 1: 115.38 / 1.086538 = 106.19 Year 2: 138.68 / 1.0865382 = 117.47 Year 3: 142.24 / 1.0865383 = 110.89 Real cash flow: NPV(All numbers are in $1000s) Notice that we get the same discounted cash flows by either method

  18. This wraps up Unit 1 • Before we leave today, I want you to introduce risk, along with some real-life applications of risky situations

  19. What is risk? • A dictionary will define risk as potential for loss • We will think of risk differently • Think of risk in this class as two or more outcomes possible • Example: Option A with probability p and Option B with probability (1 – p)

  20. Thinking about simple risks • A “fair” roulette wheel • Half of the numbers are red • Half of the numbers are black • You bet $10 • Either you win $10 or you lose $10 • Each with probability 0.5 • What about real-world problems? • What is our best guess?

  21. Thinking about a real-life application of risk • We will analyze the housing bubble of the 2000s at times throughout the rest of the quarter Source: http://mysite.verizon.net/vzeqrguz/housingbubble/

  22.  in the housing market • In most cases, the employees estimating the possible scenarios did not include the ACTUAL outcome in their estimates • For example, in Las Vegas (Feb. 2012)… • …three-quarters of homes for sale were vacant • …housing prices were at their lowest in 25 years • Recent example of a house sale • 6248 Dundee Port Avenue, Las Vegas NV 89110 (built in 1998) • 4 bedrooms • 2 bathrooms • 1,560 sq. ft. house • 7,405 sq. ft. lot • Sold June 2008 for $315K • Sold Sept. 2012 for $95K • July 2013 value: $108,501 • Oct. 2016 value: $202,724 • July 2017 value: $221,081 Source: http://www.lvrj.com/business/housing-market-sales-rise-13-percent-nationwide-140120293.html, Feb. 23, 2012 Source: http://www.zillow.com/homedetails/6248-Dundee-Port-Ave-Las-Vegas-NV-89110/7029918_zpid/, July 2013, Oct. 2016, and July 2017

  23. What happened? • The Great Recession is something that has not been seen in the United States since the 1930s • Many people underestimate outcomes with very low probabilities • Most people have difficulty incorporating low-probability events into cost-benefit analysis • Memory is also an issue

  24. 2006: POP! Source: http://mysite.verizon.net/vzeqrguz/housingbubble/

  25. Before moving on… • Some products are in fact very successful • Many toys are very risky, but some are wildly successful • Tickle Me Elmo • Zhu Zhu pets • Cabbage Patch Kids • How are toys manufactured/transported? Reminder: Test 1 coming soon Talk about calculators

  26. What is risk? • A dictionary will define risk as potential for loss • We will think of risk differently • Think of risk in this class as two or more outcomes possible • Example: Option A with probability p and Option B with probability (1 – p) • I am presenting 7.1 differently than the textbook

  27. Simple example • You are developing the next wonder drug • Unfortunately, one of your competitors is also developing a drug that will do the same thing • Whoever develops the drug first makes much higher profits

  28. The numbers • R&D costs to develop the drug are the same no matter what • $6 million in NPV • If you develop the drug first, the NPV numbers are… • Direct drug production costs of $10 million • Revenue from the drug of $20 million • If you develop the drug second, the NPV numbers are… • Direct drug production costs of $5 million • Revenue from the drug of $6 million Assigning probabilities: 50/50

  29. Calculating the expected profit • Expected costs (in millions of dollars) • 6 + (10 + 5) / 2 = 13.5 • Expected benefits (in millions of dollars) • (20 + 6) / 2 = 13 • Expected profit in NPV • -$500,000 • Investing quickly/first breakthrough

  30. Another example • You have spent $200,000 (NPV) developing a new product • Depending on market conditions, you could sell 300 units, 500 units, or 900 units of the product • If you sell 300 units, your average cost (AC) to produce the good is $500 and the price you sell the good for is $800 • 500 units… AC is $400… price is $1000 • 900 units… AC is $600… price is $1200

  31. Potential profits • 300 unit case • $200,000 in development costs • Additional costs: $500  300 = $150,000 • Revenue: $800  300 = $240,000 • Loss of $110,000 • 500 unit case (next line is in $1000s) • –200 – 0.4  500 + 1  500 • Gain of $100,000 • 900 unit case (left to student) • Gain of $340,000

  32. Calculating expected profits • Assume that… • …the 300 unit case occurs with probability 0.15 • …500 unit case… probability 0.65 • …900 unit case… probability 0.2 • The expected profit of this project is (in $1000s) • 0.15  (–110) + 0.65  (100) + 0.2  (340) = 116.5

  33. Problems using the principles from Unit 1 From Spring 2011 test If you would like to leave, please do so now or wait until I am finished with as many examples with our time remaining If you stay, you are welcome to ask questions while I go through these problems With our remaining time…

  34. Present value calculation • Assume that you receive $600 annually forever. Assume that the effective annual discount rate is 8%. Determine the present value given the following assumptions.

  35. Present value calculation • You receive the first payment today • Perpetuity formula assumes first payment is made one year from today • We must add in an additional payment today • Solution: PV = 600 + 600 / .08 = 8100

  36. Present value calculation(This was a hard question) • You receive the first payment one year from today, but you receive a payment of $300 every six months • This is trickier to do: Two ways to do it • Perpetuity every six months (and subtract first payment) • Discount the second payment each year before calculating the PV of the annuity

  37. You receive the first payment one year from today, but you receive a payment of $300 every six months • Method 1: Perpetuity every six months (and subtract first payment) • Discount rate every six months is sqrt(1.08) – 1 = .03923 • PV = 300 / .03923 – 300 / 1.03923 = $7358.44

  38. You receive the first payment one year from today, but you receive a payment of $300 every six months • Method 2: Discount the second payment each year • Discounting the second payment by six months: 300 / 1.03923 = 288.68 • PV = (300 + 288.68) / .08 = $7358.44

  39. IRR • Suppose Joanne Green invests in a new technology that makes tubeless toilet paper. Her annual discount rate is 8%. Her investment today is $50,000. The only positive cash flow she receives is three years from now, for $58,000. Her annual internal rate of return for this project is…

  40. IRR • 50,000 (1 + IRR)3 = 58,000 • IRR = 0.0507

  41. What is your risk tolerance?

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