LES SYSTEMATIC ANALYSIS: AN EXAMPLE 27 For what range of guaranty values wou! such a contract with Jones? For what range o} you be unwilling to sign? ¢ Suppose that Jones has already written out a guaranty value that is known to him but not. following deal. He will lay the contract in a eee the ae before you, and you will write down on a piece of paper the minimum guaranty value that you are willing to accept. The envelope will then be opened and if the guaranty value in the contract is at least as great as the value you wrote down, you will both sign the ‘contract; otherwise you will not sign. What minimum guaranty value would you write down? d What is the smallest cash payment for which you would be willing to sell your ticket to Doe? e If you do sell your ticket for that amount of cash, what will be the termi- nal value of your criterion? Is your answer to (d) consistent with your answer to (c)? ld you be willing to sign f guaranty values would contract containing a X18 a Same as Exercise 1.7 except that just before receiving the lottery ticket you are informed that you have inherited $3,000 from a long-forgotten uncle. b Same as Exercise 1.7 except that just before receiving the lottery ticket you are notified that the settlement of a lawsuit arising out of an auto mobile accident in which you were recently involved requires immediate payment by you of $1,000 in excess of your insurance coverage. (Re- member the availability of the $1,000 interest-free loan mentioned just before Exercise 1.3.) ¢ Same as (6) just above except that the prizes in the lottery are $2,000 for heads, $1,000 for tails, and the partial cash flows in Figure 1.10 are modified accordingly. 19 Suppose that you have for some reason or another signed a contract which obliges you to pay one James Clark $1,000 in cash tomorrow if a fairly tossed coin comes up tails; if the coin comes up heads, you will pay nothing. a What will be the terminal value of your criterion if the coin comes up heads? If it comes up tails? b What guaranteed terminal value of your criterion would you find exactly as attractive as the gamble on terminal values to which you are exposed as a result of your contract with Clark? (Remember the availability of the $1,000 interest-free loan mentioned just before Exercise 1.3.) ¢ What is the greatest amount of cash that you would be willing to pay Clark for a release from your contract? d If you do pay Clark that amount of cash, what will be the terminal value of your criterion? e Are your answers to (8) and (c) consistent? heme!28 FOUNDATIONS LEIO % 1.10 When a gamble offers even chances at two or more terminal values, the YM 412 arithmetic average of the possible values is called the “expected” terminal value, whereas the definite terminal value that is exactly as attractive as the gamble to some particular person is called that person's “certainty-equiv- alent” terminal value. The difference (expected terminal value) — (certainty-equivalent terminal value) is called a “risk premium”. a What were your risk premiums for the gambles described in Exercises 1.5, 17, 1.84, 1.85, 1.8¢, and 1.9? 5 Why should your risk premiums be exactly the same in Exercises 1.7 and 1.8c?_ In Exercises 1.86 and 1.9? ¢ If your risk premiums for the gambles described in Exercises 1.5 and 1.7 were not the same, why were they not the same? d If your risk premiums for the gambles described in Exercises 1.7, 1.84, and 1.8b were not all the same, why were they not all the same? D. ANALYSIS OF DECISION PROBLEMS Analyze the two separate decision problems described in Exercises 1.1 and 1.2, assuming as regards Exercise 1.2 that smoking is permitted in the library. (Remember the availability of the $1,000 interest-free loan men- tioned just before Exercise 1.3.) E. REVIEW EXERCISE Suppose that after telling Mr. A. H. Mallon that a prototype which may be acceptable to XYZ can be designed along conventional lines and built for a total cost of $5,000, as stated in the text, ABC’s chief design engineer goes on to say that he has an alternative idea for a radically new type of control, using transistors and printed circuits. He is not sure whether a control of this kind can be made to work at all with the components cur- rently available, but he is sure that if it actually can be made to work, its per- formance will be so superior in every respect to the units currently in use by XYZ that XYZ cannot fail to prefer it. It will cost $10,000 to build a prototype along these radically different lines, but the radical design will cost much less to produce in quantity than a conventional control; Mallon’s chief production engineer tells him that the out-of-pocket cost would be only about $7,000 for production tooling plus $12.60 per unit. Building a radical prototype will have no effect on ABC’s “other business”, but manu- facture of a production quantity according to the radical design will reduce the net contribution realized on other business from + $10,000 to + $8,000. The engineers agree that the time available before a prototype must be submitted to XYZ is sufficient to let ABC build and test a radicalLE12 SYSTEMATIC ANALYSIS: AN EXAMPLE 29 Prototype and still be able to build a conventional prototype if the radical design fails. Since XYZ is willing to consider at most one prototype from ABC and since Mallon believes that nothing could be gained by postponing the decision to build the radical design until after the conventional proto- type has been constructed and tested, Mallon has decided that if the radical Prototype is tried at all it should be built and tested before the conventional design is begun. @ Diagram Mr. Mallon’s decision problem and value the end positions. 6 Placing yourself in the role of a consultant to Mallon, decide what ques- tions you would have to ask Mallon in order to analyze his problem. Your instructor will assume the role of Mallon in class and respond to your questions with answers that Mallon might reasonably give.CHAPTER SYSTEMATIC ANALYSIS OF DECISIONS UNDER UNCERTAINTY: BASIC PRINCIPLES In Chapter I we merely suggested by means of a simple example how a problem of decision under uncertainty can be systematically described and then analyzed. In the present chapter we shall first consider carefully the basic principles that must be followed in describing the logical structure of a decision problem and the possible consequences of the available acts. Next, we shall reexamine the concept of a certainty equivalent, which lies at the heart of any method of de- composition and systematic analysis. Next, we shall state general rules for the method of analysis by evaluation of individual acts that we applied in Chapter 1; and finally, we shall describe an alternative method of analysis which often leads to a clearer understanding of certain aspects of decision under uncertainty than can be gained by thinking exclusively in terms of individual acts, The text and exercises of the present chapter are designed to be studied in the following order: 1 Section 2.1.1 and Exercise 2.1. 2 Section 2.1.2 and Exercise 2.2. 3 Section 2.1.3 and Exercise 2.3. 4 Section 2.1.4 and Exercises 2.4-2.5. 5 Sections 2.1.5-2.1.6 and Exercises 2.6-2.7. 6 Sections 2.2.1-2.2.4 and Exercises 2.8-2.10.SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 31 7 Sections 2.2.5-2.2.7 and Exercises 2.11-2. 8 Section 2.2.8 and Exercise 2.13. 9 Sections 2.3.1-2.4.3, 10 Sections 2.5.1-2.5.4 and Exercises 2.14-2.15. M1 Section 2.5.5 and Exercise 2.16. 12 Section 2.6 and Exercises 2.17-2.19. CONTENTS OF CHAPTER 2 1 Decision Problems and Decision Diagrams 1 Delimitation of a Decision Problem 2 Informational Events 3 Act and Event Forks with Many Branches 4 Successive Act or Event Forks 5 General Principles of Diagramming 6 Ordering of Forks in a Diagram 2 Valuation of Consequences 1 Detailed Descriptions of Consequences 2 Restriction to Short-term Decision Problems 3 Valuation of Monetary Consequences 4 Computation of Monetary Values 5 Description of Nonmonetary Consequences 6 Monetary Valuation of Nonmonetary Consequences 7 Salvage Value and Replacement Cost 8 Dependence of Asset Value on Other Assets 9 Share of Market and Reported Income 10 Nonmonetary Criteria 3. Certainty Equivalents 1 Definition of Certainty Equivalent 2 Certainty Equivalents and Nonmonetary Assets 3 Certainty Equivalents vs. Market Values 4 Likings for Consequences and Judgments about Chances 5 “Estimates” vs. Decisions211 32 FOUNDATIONS 4 ‘Analysis by Evaluation of Individual Acts 1 Reduction of Terminal Event Forks 2 Reduction of Terminal Act Forks 3 Analysis by Evaluation of Individual Acts 5. Analysis by Evaluation of Complete Strategies 1 Definition of Strategy 2 Strategies Implicit in a Decision Diagram 3 Analysis by Evaluation of Complete Strategies 4 Equivalence of the Two Methods of Analysis 5 Completeness of a Decision Diagram 6. ‘Summary 1 Delimitation of a Decision Problem 2 Decision Diagrams 3 Valuation of Consequences 4 Certainty Equivalents and Equivalent Decision Problems 5 Analysis by Evaluation of Individual Acts 6 Analysis by Evaluation of Complete Strategits 241 DECISION PROBLEMS AND DECISION DIAGRAMS 24.4 Delimitation of a Decision Problem When a decision maker tries to choose one among a number of possible im- mediate acts, he only rarely finds that he can foresee the ultimate consequences of all of these acts with certainty or even near certainty. Usually, the conse- quences of some if not all of the acts will depend on uncertain events, and often they will also depend on the decision maker's own future acts; and therefore the decision maker usually cannot make a reasoned choice among the various im- mediate acts that he is considering without systematically evaluating the possible effects of future acts and uncertain events on the consequences of the immediate acts. ‘On the other hand, it is never possible to take explicit account of all the future acts and uncertain events that may affect the ultimate consequences of an immediate act, since to do so the decision maker would have to look indefi-assible im- ‘sequences the conse- and often srefore the arious im- re possible immediate sunt of all quences of d0k indefi- 33 212 SYSTEMATIC ANALYSIS: BASIC PRINCIPLES hitely far into the future. The decision maker must necessarily delimit 7 decision problem by sclecting some definite fur >. The general nature of such a diagram is suggested by the example in Figure 1.5 (page 13), but before giving general rules for diagram- ming decision problems we shall do well to look at certain complexities that appear in many problems even though they did not appear in that very simple example. 2.1.2 Informational Events The only events that appeared in the decision diagrams in Chapter I were events which would have a direct effect on the consequence of an immediate act, but in many decision problems the decision maker will wish also to take account of various events which will not have any direct effect on the consequence of any immediate act but will provide information that may affect his future acts and thus have an indirect effect on the consequences of the immediate acts. For example, suppose that Mr. A. H. Mallon of ABC Controls had believed that a competitor was experimenting with the use of stamped parts in control units similar to those Mallon would build for XYZ, and suppose that Mallon thought he might learn whether the results of this experiment were “favorable” or “unfavorable” to the suitability of stampings in the XYZ ap- plication before he would actually be obliged to choose between stampings and machinings. In these circumstances the subdiagram emanating from position X in Figure 1.5 would have had to be replaced by the more complex subdiagram shown in Figure 2.1 below. Using Figure 2.1, Mallon might very well have decided, for example, that if and when he reached position A or C, he would use stampings, whereas if he reached position B, he would use machinings. He might have decided, in other words, to his choice between stampings and machinings on the new information. Because the diagram in Figure 1.5 does not show the possibility of such conditioning, it would under our present assumptions be an incorrect description of Mallon’s decision problem; and it goes without saying that a correct analysis cannot be based on an incorrect description.34 FOUNDATIONS 2.1.3 Termin net Event Event Act Event quid ossets FIGURE 2.1 ‘Subdiagram Showing Informational Events 213 Act and Event Forks with Many Branches Although none of the act and event forks in Figure 1.5 (page 13) had more than two branches, forks with more than two branches appear frequently in decision diagrams, and some forks will have so many branches that it is impractical to show them all explicitly on the decision diagram. For example, suppose that, instead of feeling sure that:the cost of pro- duction with all machined parts would amount to exactly $95,000 exclusive of tooling costs, as shown on the branch labelled ‘“machinings work” in Figure 1.2 (page 9), Mr. A. H. Mallon had felt that this cost might be anywhere between. say, $76,000 and $114,000. Since each possible value of the uncertain cost isa possible event, this additional uncertainty would have had to be represented in Mallon’s decision diagram by putting an event fork with one branch for each possible cost in place of the single branch labelled “machinings work” with its associated —$95,000 cash flow. This fork would have had thousands of branches, however, and it is neither necessary nor feasible actually to draw each individual branch on such a fork. The uncertainty can be adequately repre- sented by a schematic fork or > of the sort shown in Figure 2.2.SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 35 Tool to machine Act Event FIGURE 2.2 Event Fan Representing an Uncertain Cost ' The event fan in Figure 2.2 is to be understood as having one branch ‘Or each possible event or possible value of the uncertain cost that the fan Tep- Tesents. The symbol x on the typical branch>> stands for the typical value>> ; .¢., for any possible value—of the uncertain cost, —x being the resulting cash low. _Fans will often be needed to represent choices among acts as well as uncertainties concerning events. For example, suppose that a businessman must decide what price to bid in competing for a certain contract. Each possible bid Price is a possible act, and the acts which the businessman wishes to consider may well be so numerous that they must be represented schematically by a fan rather than literally by a fork. When a fan occurs in the “interior” of a diagram rather than at the end, the entire diagram beyond the fan becomes schematic rather than literal. If, for example, the only events concerning which the businessman of our last example is uncertain are the events “win contract” and “lose contract”, his entire decision problem might be represented by the diagram in Figure 2.3, which is to be interpreted not only as if the act fan had one branch for every possible act or bid price x but also as if every one of these act branches were followed by an event fork exactly like the event fork that is actually drawn after the typical act branch. 214 Successive Act or Event Forks The set of acts or events represented by any fork that has more than two branches can be equally well represented by a sequence of forks each of which has a smaller number of branches. For example, suppose that, instead of believing ~ pet (bid price) Event FIGURE 2.3 Decision Diagram with an Interior FanA Tool to stomp Ae Event Event ¢ ges ® Teol to stomp Act Event Event FIGURE 2.4 Alternate Representations of an Uncertainty that controls with stamped parts would either give complete satisfaction or fail completely and have to be replaced by controls with all machined parts, Mr. A. H. Mallon had felt that there was an intermediate possibility, namely that controls with stamped parts would have to be adjusted by hand at considerable cost. To show this additional possibility on his decision diagram, Mallon could have replaced the two-branched fork at Y in Figure 1.5 (page 13) by the three- branched fork in Figure 2.4A above, but he could equally well have replaced it by either of the sequences of event forks shown in parts B and C of that same figure. All three representations of possible events in Figure 2.4 are logically equivalent because they all lead from position Y to three positions, L, M, and N, each of which has exactly the same meaning in any one representation as in any other. We leave it to the reader to invent examples of different logically equiv- alent representations of choices among three or more acts. Which of the various possible representations of a set of possible acts should be used in a decision diagram is purely a matter of convenience. As regards representation of events, on the contrary, we shall see later on how choice of one representation rather than another may enable the decision maker to exercise his judgment more effectively when he comes to the actual analysis of his decision problem. 36oe 15 SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 37 24.5 General Principles of Diagramming ie Sxamples of decision diagrams and Subdiagrams that we have now examined P ee Suffice to make clear the meaning of the general principles that must be cllowed in describing any decision problem by a diagram, Even though th v decision maker's only immediate problem is to choose an immediate act, the decision diagram must show not only Nera _ must sho 1 All immediate acts among beat also 2 All uncertain events and future acts that the decision maker wishes to consider because they may directly affect the consequences of the im- mediate acts, 1g which the decision maker wishes to choose, and 3 All uncertain events that the decision maker wishes to consider because they may provide information that can affect hs, future choices among acts and hence indirectly affect the consequences of immediate acts. Events may of course have both direct and indirect effects ‘on the consequences of immediate acts, AAn individual act or event is represented in the diagram by a branch; either end of any branch is call led a position. A among possible cis is represented by an act fork consisting of a number of act branches all of Which emanate from a single postion called the base of the fork: an regarding events is Tepresented by an event fork consisting of a number of event branches all of which emanate from a single position, again called the base of the fork. & The events on any event fork or the acts on any act fork must be () mutually exclusive>> in the sense that no more than one of them can possibly occur or be chosen, and (2) collectively exhaustive>> in the sense that in the decision maker's judgment some one of them must ‘occur or be chosen. Observe that this definition of “collectively exhaustive” leaves the decision maker free to exclude from the diagram acts which he does not wish to consider and events which he believes to be Practically certain not to occur. ‘The complete decision diagram takes the form of a “tree” with succes- Sive branchings; a very simple example was shown in Figure 1.5 on page 13. At the origin of the diagram there is a single act fork representing the decision maker’s choice among the immediate acts that he wishes to consider. Each branch of this initial fork may lead either @ to an end position of the diagram, indicating that choice of the corresponding act puts an end to the de- cision problem, or (b) to another fork representing either another choice by the= FOUNDATIONS 215 decision maker or the decision maker's uncertainty concerning a set of mutually exclusive and collectively exhaustive events. On the initial fork in Figure 1.5, the branch representing the act “do not build prototype” led to an end position; the branch representing the act “build prototype” led to another fork represent- ing the decision maker's uncertainty about the mutually exclusive events “XYZ orders” and “XYZ does not orde Like the branches of the initial fork, the branches of subsequent forks may lead either to end positions or to still other forks; and so forth until finally all branches have led to end positions. : The order in which particular act and event forks appear in the decision diagram must agree with the following: Basic Ordering Principle The acts and events along the path from the origin of a decision diagram to the base of any act fork must give a cor- ect representation of the information that will and will not be available to the decision maker when he actually has to make the choice repre- sented by the act fork in question. This principle is of such crucial importance that we shall devote the next section to a detailed examination of its implications. 2.1.6 Ordering of Forks in a Diagram ‘The basic ordering principle which was stated at the end of the last section is a Consequence of two more basic propositions about the analysis of decisions under uncertainty. 1 Ifthe decision maker will not have to make an irrevocable choice among a number of mutually exclusive acts until after he has learned which of a number of mutually exclusive events actually occurred or will occur, then as we saw in Section 2.1.2 he may wish to condition his choice— i.e., make it depend—on the event that actually occurs. To show the possibility of such conditioning diagrammatically, a fork representing the decision maker’s choice among acts must follow each branch rep- resenting an event which might occur 2 If on the contrary the decision maker will have to make an irrevocable choice among a number of mutually exclusive acts before he has learned which of a number of mutually exclusive events has occurred or will occur, then he cannot condition his choice on the event that actually occurs. To show the impossibility of such conditioning diagram- matically, the fork representing the choice among acts must precede all branches representing the possible events.9 2.16 SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 3 Chronological Ordering A decision diagram will necessarily represent possible Conditionings correctly if the order in which act and event forks appear in the diagram agrees with the chronological order in which the decision maker's choices will have to be irrevocably made and his uncertainties will be resolved. In Figure 1.5, the act fork representing A. H. Mallon’s choice between “build Prototype” and “do not build” appeared before the event fork representing his uncertainty about the events “XYZ orders” and “XYZ does not order” because the choice in question had to be made before the uncertainty in question could possibly be resolved. Observe that: 1 As regards choices, what counts in determinining chronological order is the date at which one of the acts on an act fork will have to be chosen irrevocably. A choice which can be revoked later at no cost is not a choice; a choice which can be revoked later at a cost is really a sequence of two choices at different dates and must be diagrammed as such. 2. As regirds uncertainties, what counts in determining chronological order is not the date at which one of the events on an event fork actually ‘occurs but the date at which the decision maker’s uncertainty about the events is resolved. If A. H. Mallon would like to base his choice between stampings and the machin ings on the outcome of a competitor’s experiment with stampings, the date that is relevant to Mallon’s decision problem is not the date at which the experiment will be conducted and its outcome or event will be determined; it is the date at which Mallon’s uncertainty about the experiment will be resolved through his learning what event occurred. If the decision maker does not know whether his uncertainty about a particular set of mutually exclusive events will or will not be resolved before he has to make a particular choice among acts, this uncertainty about chronological order must also be represented in the decision diagram. Figure 2.1 (page 34) shows how Mallon could have represented his XYZ decision problem if he had (a) believed that a competitor’s experiment with stampings would yield informa- tion bearing on the suitability of stampings for Mallon’s own purpose, but ? (®) been uncertain whether he would learn the outcome of this experiment before ‘ or after the date at which he would have to make his final decision about the use of stampings. i Permissible Departures from Chronological Ordering Although possible con- ditionings of acts can always be correctly represented by constructing a diagram which is in strict agreement with chronological order as defined above, certain departures from strict chronological order are permissible and often facilitate diagramming considerably. Specifically : AiFOUNDATIONS, 216 1. Two or more choic i i it cis "es may be diagrammed in an order different from they will actually be made if the decision maker will learn of no cen between the carliest and latest dates at which the various choices must be le. : 2. Two or more uncertainties may be diagrammed in an order different from that in which they will actually be resolved if the decision maker will choose no act between the earliest and latest dates at which the various uncertainties will be resolved. The fact that uncertainties can under appropriate conditions be dia- grammed in an order different fi : from that in which they will actually be resolved can be of considerable practical importance in either of two ways. (1) It follows from this fact that it is not alway us fact ayS Necessary to show on the diagram all possible orders in which a number of uncertainties may be resolved. (2) Diagramming Uncertainties in an order other than that in which they will actually be resolved may, for reasons which we shall be able to explain later on, enable the decision maker to exercise his judgment more effectively when he comes to the actual analysis of his decision problem. 22 VALUATION OF CONSEQUENCES 224 Detailed Descriptions of Consequences After the decision maker has constructed a diagram of his decision problem, he must next consider in turn each possible act-event sequence that is shown on the diagram and write down an adequate description of the consequence of that Sequence. By “adequate” we mean, of course, adequate in the decision maker's judgment for the purpose at hand. The description must reflect every aspect of the consequence that the decision maker wishes to consider in arriving at his final decision. ‘An adequate description of the consequence of an act-event sequence may be very complex, including not only statements concerning the financial effects of the sequence but also statements concerning the effects of the sequence on the physical assets, technological know-how, and business reputation of the decision maker’s company, statements concerning its effects on the behavior of various people, and possibly also a statement concerning its effects on the deci- sion maker's own personal position and reputation and psychological well-being. What is more, the date at which each of these effects occurs will in general be of importance to the decision maker and will therefore have to be included in the description.2.2.3 SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 41 2.22 Restriction to Short-term Decision Problems Systematic analysis of a decision problem along the lines suggested in Chap- ter | would, of course, be exceedingly difficult if all or many of the possible consequences in the problem had very complex descriptions, but fortunately Such detailed descriptions can often be replaced by much simpler descriptions which are nevertheless equally adequate in the sense of the previous section. Specifically, the decision maker can often reduce the detailed description of each consequence in a decision problem to a single number which in a suitable sense tepresents the “value” of that consequence and which therefore constitutes an adequate even though condensed description of the consequence. Because finding appropriate values for the consequences in a given decision problem is usually relatively easy when all the dates that are involved in the detailed descriptions of the consequences are virtually the same but is often extremely difficult when these dates are widely spaced out in time, the discussion in this book will be restricted to > decision problems in which consequences can be adequately described without use of dates. This restriction does not mean that we are excluding from consideration all problems in which the dates at which various acts and events actually occur Jead to payments of interest by or to the decision maker’s company; but it does mean that we are excluding all problems in which the importance of dates cannot be completely allowed for by simply including the amount of interest paid or received in the description of a consequence. In particular, all problems in- volving changes in long-term debt are excluded from the discussion in this book. In most decision problems of the sort to which we have restricted our discussion, the easiest way to attach an appropriate value to each consequence is to start by attaching a monetary value to the purely financial or monetary effects of each act-event sequence and then to adjust this monetary value to allow for the nonmonetary effects of the sequence. After we have discussed the two steps in this procedure in some detail, we shall suggest how it may be possible to find nonmonetary values for consequences in situations where our procedure for assigning monetary values is hard to apply. 2.2.3 Valuation of Monetary Consequences Although the consequences of the various act-event sequences in A. H. Mallon’s XYZ decision problem were completely described by the total cash flows shown at the end positions of Figure 1.3 (page 11), Mallon did not wish to base his analysis of the problem on these descriptions, He felt that he could not properly evaluate the various possible consequences uniess he viewed them in their business context; and to do so in the way that was most meaningful to him, he first selected his net liquid assets as the by which he would evaluate the42 FOUNDATIONS 2.23 Consequences and he then proceeded as shown in Figure 1.5 (page 13) to replace each total cash fi total Ow on his decision diagram by the resulting > of his criterion—ice,, the Value of his net liquid assets on his chosen evaluation date, The implications of this example are quite general. will usually b A decision maker Much better able to evaluate the monetary cot aS a result of the act-event sequence. bligations to pay enforced in the near futur What is to be conside red the “near” future in an: decision maker. a transfer of cash is in the 'Y particular situation is up to the “near” future if the only importance ifference between his evaluation date Will actually take place is due to the effect of this differe interest paid or earned. ‘nce on the amount of i 2.24 Computation of Monetary Values In order to compute the terminal y; Particular act-event sequence in a alue of his criterion that wil we shall simply make the term “ we shall henceforth use follows: ‘cash flow” serve both the expression “ Purposes.' In other Words, cash flow” as a technical term defined as | The term “funds flow" includes chan, ges in long-term financial claims as well as changes in short-term claims and actual transfers of cash,2.24 SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 43 @ Any change in net liquid assets will be called a cash flow>>. An in- Crease in net liquid assets will be called a cash inflow and will be treated as algebraically positive; a decrease in net liquid assets will be called a cash outflow and will be treated as algebraically negative. Partial and Total Cash Flows The various acts and events that make up any one act-event sequence in a decision problem will in general give rise to a great number of individual cash flows representing individual items of cost, expense, and revenue, Although all that the decision maker needs to know about these flows in order to compute the terminal value of his criterion is their aggregate or net amount, it is easy to overlook some of the individual flows in computing the Aggregate, and therefore it will often be advisable to carry out this computation by a systematic two-stage procedure of the sort that we applied to A. H. Mallon’s decision problem in Sections 1.1.3 and 1.1.4. 1 The decision maker first writes down on each branch of the decision diagram the > net cash flow he attributes to the individual act or event represented by the branch in question, using a plus sign to desig- nate a net inflow, a minus sign to designate a net outflow. The partial cash flows in Mallon’s problem were shown in Figure 1.2 (page 9). 2 The decision maker then computes the > net cash flow that will result from each act-event sequence by simply f following the correspond- ing path through the diagram and computing the algebraic sum of the Partial flows that he has written down on the branches that make up this path; after which he erases the partial cash flows from the diagram and never refers to them again. The total cash flows in Mallon’s problem were shown in Figure 1.3 (page 11). A great deal of latitude is permissible in deciding just which individual cash flows are to be included in the partial net cash flow that is attributed to any one individual act or event. Consider, for example, the portion of Figure 1.2 which is reproduced as Figure 2.5A below. The Partial flows shown in this figure were arrived at by attributing to the act “tool to stamp” only the minimum tool- j ing cost to which that act would lead, all subsequent production costs being attributed to one or the other of the two events “stampings work” and “‘stamp- ings do not work”, but we could have argued equally well that the act “tool to stamp” would necessarily lead to total production costs amouting to at least $14,000 + $82,000 = $96,000, which would be augmented by $15,000 if stamp- ings failed to work. This latter line of argument would have led to the partial cash flows shown in Figure 2.5B rather than the quite different flows shown in Figure 2.5A, but because the total cash flow assigned to any act-event sequence will have exactly the same value if it is computed from the partial lows in Figure Ditetettecmnmen44 FOUNDATIONS 2.24 Tool to stomp ~ $96,000 Bet FIGURE 2.5 Alternate Values for Partial Cash Flows Event 2.5B as it will if it is computed from the partial flows in Figure 2.5A, either set of partial flows is as correct as the other. What is suggested by this example is true in general. The analyst is free to define the partial cash flow attributable to any one act or event in any way that he finds convenient, but he must make all of his partial flows consistent in the sense that the total flows to which they lead are correct. He must take care that (1) every individual cash flow that will actually occur as a result of any given act-event sequence is attributed to some act or event along the path representing the sequence, and (2) no individual cash flow is attributed to more than one act or event. Timing of Cash Flows; Interest Payments and Infeasible Acts Even in short-term decision problems, the dates at which certain cash flows will actually occur are often of very real importance. The interest payments to which a given act-event sequence gives rise will in general depend on the dates at which the other cash flows associated with that sequence occur; and it may even happen that certain acts which would otherwise be feasible are infeasible because they call for exces- sively large cash outlays to be made before the covering inflows are received. In most situations where the timing of cash flows is important, for either of the reasons just mentioned, the timing of the flows and its implications will have to be analyzed on a work sheet separate from the decision diagram. The relevant timing information cannot in general be shown on the diagram because the cash flow or flows to which a given act or event gives rise do not in general take place at the same time at which the decision maker chooses the act or learns of the event, and it is this latter time that determines the position of the branch in the decision diagram. Contextual Cash Flows We call the reader's particular attention to the very important fact that the terminal values of the decision maker's criterion cannotrh 2.5 SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 45 be computed unless he has shown on his decision diagram not only the cash flows that are directly associated with the decision problem at hand but also all cash flows that will result from his “other business. Even if these “other” poke will be completely unaffected by any of the possible acts or events in the decision diagram, they must be included in order to enable the decision maker to view the consequences of these acts and events in their business context; and if there is any uncertainty about the other flows, this uncertainty must be ex- plicitly represented in the decision diagram. In what follows, we shall use the term contextual cash flow> to denote a cash flow which is not directly associated with the decision problem at hand but ‘will nevertheless affect the value of the decision maker's criterion on his evaluation date. 2.2.5 Description of Nonmonetary Consequences Having seen how the decision maker can evaluate the purely monetary conse- quences of the possible act-event sequences in a decision problem, we next ask how he can evaluate the nonmonetary consequences, and as a starting point, we remind the reader that our essential conclusion concerning the evaluation of monetary consequences was that these consequences should be viewed in their business context. To make sure that they were in fact viewed in this way, we fended that the decision maker should in general base his analysis, not on the cash flows or changes in financial position that would result from the various act-event sequences in his decision problem, but on some criterion or measure of the resulting financial position itself—e.g., his net liquid assets. The same reasoning that led to this conclusion regarding the evaluation of monetary consequences leads to a similar conclusion regarding nonmonetary consequences. Whether or not the decision maker starts by writing down a description of the nonmonetary changes in his general business position that will result from each possible act-event sequence, his actual analysis of the problem should be based, not on descriptions of changes, but on descriptions of the actual business positions in which he may find himself on his evaluation date as a result of these changes. Jn what follows, we shall refer to the nonmonetary aspects of the deci- sion maker’s general business position as his . Notice, however, that the word “asset” is here to be interpreted, not in the accounting sense, but as meaning anything to which the decision maker attaches value. The decision maker’s business reputation or psychological well-being is as much an asset in the sense in which we shall use the word as his plant and equipment; and from our point of view, a debt is a negative asset rather than a separate kind of entity called a liability. The principle of evaluation by assets rather than changes in assets can- not, however, be usefully applied to nonmonetary assets until we have found a way of circumventing a difficulty that does not arise when the principle is applied# FOUNDATIONS 2.2.5 ‘oshort-term monetary assets. The decision maker's net liquid assets at any end Position of his decision diagram can be completely described by a single number, buta description Of his total tangible and intangible nonmonetary assets at any end position would virtually always constitute so large a document that it would be completely useless as a basis for analysis. A way out of this difficulty can be found as soon as we stop to think that most of the decision maker’s tangible and intangible nonmonetary assets will be exactly the same at any one end position of his decision diagram as they are at any other, and the decision maker will almost certainly already have in mind a Very good idea of this common asset base when he sets out to analyze his decision Problem. Only the differences between his nonmonetary assets at various end Positions Tequire explicit description, and the decision maker can describe these differences systematically by proceeding as follows: a The decision maker first selects some one end position as a base end Position>> and thinks of his total nonmonetary assets at this end posi- tion as constituting his . 2 He then writes down opposite each other end position a careful state- ment of all the differences between his base nonmonetary assets and the nonmonetary assets he will have at that end position. For example, let us now be a little more realistic about A. H. Mallon’s XYZ decision problem and admit that Mallon would have wanted to take ac- count, not only of the purely monetary consequences of the various act-event sequences in Figure 1.5 (page 13), but also of the fact that one of these sequences would leave him in possession of the tooling required to produce control units using all machined parts, another with the tooling required to produce them using some stamped parts, and another (the sequence involving the event “stamp- ings do not work”) with the tooling required to produce them in either one of these two ways. If Mallon chooses as his base end position the position follow- ing the act “‘do not build prototype”, he can describe the difference between his base nonmonetary assets and the nonmonetary assets he will have at each other end position by simply mentioning the special tooling (if any) that will be present at that end position. 2.2.6 Monetary Valuation of Nonmonetary Consequences Now that we have shown how the decision maker can systematically describe the assets—monetary and nonmonetary, tangible and intangible—that he will have at any end position of his decision diagram, we are ready to show how he can reduce each of these descriptions to a single number that in a suitable sense expresses the value of the end position to him.SYSTEMATIC ANALYSIS: BASIC PRINCIPLES 47 To start with an example, suppose that A. H. Mallon takes as his base end position the end position following “do not build prototype”, and Suppose that he feels that the only significant nonmonetary difference between his base end position and the end Position following “tool to machine” is the presence at the latter of the tooling acquired to produce with all machined parts. Mallon can assign an appropriate monetary value to this leftover tooling by simply de- ciding for exactly how much cash he would be just willing to agree now to sell the tooling if and when he arrives at the end position following “tool to ma- chine”. For if he decides, say, that he would be just willing to agree to sell the tooling for $2,000, then the total assets at the end position following “tool to machine” must be exactly as attractive to him as they would be if the leftover tooling at that position were in fact replaced by an extra $2,000 of cash; and therefore he will make no error in the analysis of his decision problem if he (1) adds $2,000 to the net liquid assets that he will actually have at the end posi- tion following “tool to machine”, and then (2) erases the mention of special tooling from his description of his assets at that end position and forgets all about it in analyzing his decision problem. If Mallon believes that one of the end positions in his decision diagram icantly superior to the base end Position in respect to some intangible and nonsaleable asset (such as general business reputation) rather than a tangible and saleable asset (such as tooling), he may find it hard to assign a monetary value to the “additional” reputation he will have at the end position in question by thinking about Selling this additional reputation as such, but he can ac- complish the same purpose by deciding for how much cash received on his evaluation date he would be Just willing to agree now to divest himself of all benefits that he might derive from this additional reputation after his evaluation date. For the sake of brevity, however, we shall in what follows talk simply about the price for which the decision maker would be just willing to agree now to “sell” an asset or an additional amount of an asset if and when he arrives at a particular end position, leaving it to the reader to decide exactly how the decision maker should interpret the word “sell” in any particular case. In the two examples just discussed we considered the case where at a given end position the decision maker either possesses an asset (tooling) which he does not possess at the base end Position or possesses “more” (general business reputation) than he does at the base end position. TI relation can of course also occur—at a given end position the deci: may either not possess an asset which he Possesses at the base end Possess “less” of the asset than he does at the base end position. In order to assign a monetary value to such a “1 the decision maker must decide on the cash: price for willing to agree now to buy the missing asset if and Position in question. is signifi of an asset he opposite ision maker Position or negative” asset difference, r which he would be just when he arrives at the end He can then subtract this Price from the actual value of his monetary criterion at the end Position in question and proceed to analyze