Hello guys welcome to a new month, you might be wondering
why am particular about this month, why not other months; well it’s my birth
month and I want to recognise all the August born in the house!
We are kind of special you know.
Back to the matter, today we are going to look at Expected
Value as a decision making tool in Risk and Uncertain scenario
First what is Risk, and Uncertainty?
Riskis a situation
where the future outcome a decision taken could be any of several possibilities.
Uncertaintywhen
the outcome of decision cannot be ascertained or quantified due to insufficient
information, we refer to it as an uncertain situation.
Reducing uncertainty will require being able to source for
more information.
We have various other techniques that we can use to evaluate
various decision options by the nature of risk and return. They include;
1 Expected Value
(our main focus)
2 Maximax
3 Minimax and;
4 Regret Rule
Expected Value
Expected
Value is analysis tool used in assessing the risk component and the probable
outcome in different scenarios. Using Expected Value, probabilities are
assigned to different outcomes and decision made by evaluating the weighted
average of these outcomes.
A decision is the made by selecting the course of action
that offers the highest Expected Value of profit, or the lowest Expected Value
of cost. In other words, the ‘decision rule’ is to select the course of action
with the highest Expected Value of profit or the lowest Expected Value of cost.
Expected Value is calculated as the Sum of weighted average
of possible outcome
Expected
Value =∑px
Where
p=possible
outcome
x=probability
Let’s try out our understanding of the topic, by trying out this
example.
·
It is always important to use a ‘payoff’
table in calculating the EV. ‘payoff’ table is simply a table that shows all
possible result from the different decisions.*
X Ltd can choose from five mutually exclusive projects. The projects
will last for one year only and their net cash inflows will be determined by
the prevailing market conditions. The forecast annual cash inflows and their associated
probabilities are shown below
Market
Condition

Poor

Good

Excellent

Probability

0.20

0.50

0.30


N’000’

N’000’

N’000’

Project
L

500

470

550

Project
M

400

550

570

Project
N

450

400

475

Project
O

360

400

420

Project
P

600

500

425

Based on the expected value of the net cash inflows which
project should be undertaken

Project L


Outcome


Probability

Expected
Value


N’000’


N’000’

Poor

500

0.20

100

Good

470

0.50

235

Excellent

550

0.30

165

Expected
Value

500


Project M


Outcome


Probability

Expected
Value


N’000’


N’000’

Poor

400

0.20

80

Good

550

0.50

275

Excellent

570

0.30

171

Expected
Value

526


Project N


Outcome


Probability

Expected
Value


N’000’


N’000’

Poor

450

0.20

90

Good

400

0.50

200

Excellent

475

0.30

143

Expected
Value

433


Project O


Outcome


Probability

Expected
Value


N’000’


N’000’

Poor

360

0.20

72

Good

400

0.50

200

Excellent

420

0.30

126

Expected
Value

390


Project P


Outcome


Probability

Expected
Value


N’000’


N’000’

Poor

600

0.20

120

Good

500

0.50

250

Excellent

425

0.30

128

Expected
Value

498

Project M yielded the highest EV in terms of profitability,
therefore the management ‘decision rule’ will be to go for project M
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