1222 Bronte Denopmet conditions which the management thnks are likely to occur in the tre Decision Making Under Diferent Conditions In a ssa teument of deciion making, dvson aes tobe countered unde four condition (1) Certainty (rk (@) un ‘sings and (0) conlice: Decisions ae being made under condos of ceraingy when hee is smn to be only one conpoquence ot uteome of cach of the options salable tothe deci maker ‘Alteraively the condom of esi acer when the deco taker certain which sat of ature il occur He muse therefore ‘hows the best cure of ston, Sich «decision models knows 1 deceit decision model Decisions ar mit he taken under ‘isk? when the decision maker has faced the sme ston repel and ean tesonly ensue relive freueneydntrbuion fr the cxcuence of thee sates of mate Inter words nthe cs of decison making nde rk theres more than one posible payoff ekg om the selection of «strategy and she deion makers abued to koow the probability of occurence of exch of these pay The ‘ariaons of pays re the em of factors ouside he conc of desma Decisions are sad co be made under uncertainty” when neither the number of possible future states nor thir probable of occur ence are known to the decision maker. The decision maker's jgnor- ‘ance under the condition called uncertainty may be only parti ‘The condition of ‘conflict’ arses when the only information about the occurrence ofthe state of natre is that an Opponent is present ‘who will cto arm the decision-maker. Ip this ate te occurence of any state of nature is dependent upon the opponents action, ‘Under conflicts normally assumed thatthe action ofthe decision ‘maker or his opponents taken without she knowledge of the action taken by the other. Since the decison with cerainty imply. the 8000 10,000 Yer? 000 12,00, Year} 4000-6000 [Rishles eat of recor i 5%. Project X sls risky as compared tw Project Y. The management considers risk premium rates a 3% lind 10% respectively approprite for discounting the cash inflows State which project i Beer? Solution Risk-Adjusted Discount Rate will be Project X 5+ 5 = 10% CALCULATION OF NPY. ATRADR. Projsce X Project ¥ Cah PVE. Cah” PVE. Yes Inflows at 10% PY. _Iaflows a 15% _ PY. Oe 8. 4 oO Oo 1 8000 9097272 10000 870 8700 2 8000 4% GOB 12000756 9:07? 3 the Jr Same “Simos reat 770 cage A amp, a Since N-PN. i postive in the ease of project Y, Y is superior 0X.120. Enreprneil Desomen™ J. Cemranvry - Equivaenr CosrricieNr ArpRoActt “This ssk clement in any decision is often characterised by two ‘Outcomes: the ‘potential gun’ at the one end and the “potential loss a che other. These ae respectively called the focal gain and focal loss. In this connection, Shackle proposes th concept of "po- tential surprise” whichis «unit of meavurement indicating the de- sion-maker’s surprise atthe occurrence of an event cher than what he was expecting He also introduces another concept — the “eerainyy equivalent” of risky investment. For an investment X wvith a given degree of risk, investor ean always find another iklese investment X, such tha hei indifferent between X and X,. The diference between X and X, is implcly the risk discount. ‘The riskiness ofthe projectunderthismethod is taken nto acount by adjusting the expected cash inflows and the discount rate, Thus the expected cash inflows are reduced to conservative level by 3 risk-adjustment factor (aso called correction factor). This factor i expressed in terms of certainty - Equivalent Co-effcient which i the ratio of riskless cashflows to sky cath flows, Thus certainty Equivalent Riskless Cash flows Cah flows = Risky cashflows such co-efficient is ealeulated for cash lows af each yest. The value of the co-efficient may vary between O and 1 and there is inverse relationship between the degree of risk and the value of co-efficient computed, ‘These adjusted cash inflows ate sed for calculating N.P.V. and the ERR. The discount rate to be wsed for‘calculating present values will be risk-free eae (i.e, the rate reflecting the time vale ‘of money). Using this criterion of the N.P-V. the project would be accepted if the NPV. is positive, otherwise it would be rected ‘The LRR. willbe compared with risk free discount rate and i it is higher the project wil be acepted, otherwise rejected Mstration X.Y, Limited employsthe certainty equivalentapproachin the eval avon of risky investments, The captal budgeting department has processed the following information regarding 3 new project Medios of Pofiaiy Appa 231 Cost of initial snvesement Rs, 100,000. Cath inflows after axe Year Amount Certainty Equivalent Coefficient Re 1 0.00 8 2 70,000 7 3 65,000 6 4 ‘6,000 a 5 49,000 3 : “The company’s cost of equity capitals 18% its cos of debts 9% and the isles rate of interest in the market on government Sec- trite is 6b, Should the project be accepted? Solution ‘CALCULATION OF N.PW. OF ADJUSTED CASH INFLOWS, [AT RISKLESS RATE ) ‘Adjusied Cah ‘Cah PE. Yer Inflows CEC. Inilows 206% PY. ph iG Nr Ole AEST LO Tocco 84000, GD 2 0007) 890 3,610 3 006330 HO 760 4 seo) 424000792 19,008 $4003 tz 47 364 ESS ARGS ES Sa eee ra Less: Cost 100,000 HE iloe: Cont aE on NPV 469 ‘Hence, Project should be accepted 4. PRosasiuity AppnoscHe Probebilty means the likelihood of happening of an event. Te varies from zero to unity (1). When i is zero ie means tht event isnot22 Exner Decament eng 1 happen; when i 1 means thatthe even is bound to Kapp (ie certain to happen} ‘The probably theory approsch to expected cash inflows would provide more precise mearar of varity in ath inflows This ‘etd considers a wholerange of posible rs retarn combinations ‘lich can adequately represen thefull ange ofalterativeouteomes { aiky underahing Therefor, eis necessary to consider age umber of altrative cash flows andthe asocited probable, for exch period under consideration. Under his method the probability of occurrence of parclar cash inflow emater shoold be asigned to that eximat. The cash inflow estimates should then be mulpied bythe probable as- signed to them andthe renhaot gars are own as expected tmonetary values, These expected monetary values are then di- counted es given rate to provide presen vahes and NBN. Maseraton ‘The following information is available regarding the expected cash inflows generated and ther probabilities of X Limited in respect of 4 project requiting an initial investment of Rs. 40,00. PROBABILITY Gash Inflows Rs. Is Yer Mind Year Wed Year o @ 0) « 10,00 050 050 070 20,000 025 040 030 30,000 01s 210 0.00 40,000 010 2.00 0.09 ‘Assume 8% as discount rate, find the net presen values of ex- pected monetary value, Maas of Pofcy Arpaia 293 ALTERNATIVE CASH INFLOWS [AND ASSOCIATED PROBABILITIES Int Year Year MM Year Cah Probab apace Poi Expecad Probably Expeced Ialowe Yaar ae eure Re, Oye ead yay ee ee 10000 080 Som 050 som 9707000 Stoo 028 soo cao fom) 030.00 stom ois soo 010 30m ow 4900010 __ 4000 000 _._0.00 ‘Toul 1.00 18,500 1.00 16,000__1.00_ 13,000 “This the expected value of returns with probability 1 are Rs. 16,300 in the fot year, Ri 16000 in the 2nd year, and Rs. 1,300, in the 3rd year. “These expected returns may now be discounted to thir present value npc Miner Vine Pre Val Pret Ye Yer ie Fawr 5% % 1 183500 952 17622 2 16,00 307 w4si2 é. 1300 Ae cc sid eae nee Gross Prat Vahe 43,356 Les: Cah ondow _40,000 [Net present value 3,386 Since there isan excess present value of Rs. 3,356 the Project can bbe accepted. Limitation of Probabilistic Approach ‘This method however has» limited application, Ie an be applied only i large number of similar investments are ro be undertaken tnd if One project fils to yield the expected return, others fare 0 well thatthe loss is more than compensated, as it happens284. ExepreeaDesdopment in the cate of insurance policies. This method has however a {reat deal of application to the problem of portfolio selection ‘of securities je, optimum of combination of stocks, bonds fovernment secures and other financial instrument. 5. Sexsrrivery ANALYSIS Sensitivity analysis examines how sensitive the calculated present ‘ale figure i tothe likely charges in the value of the strategic Taables entering into the decision process. Since che furure is tlways uncertin, there will always be some estimation errors fand sensitivity analysis takes care of such estimation errors by providing a number of expected cash inflows for each year (as Ueainst single estimate of eath iaflows for each year). Cash inflow estimates are provided in this method under () pessimistic (ovorst) (i) most likely (expected) and (ii) optimistic (best) futcomes asodiated withthe project and the corresponding NPV fre clealated. ‘The caleulated NPV for all these alternative Situatiogs in cate of each of the uncertain variables are then faken together and analysed to arrive at « decision, The lager is the difference berween pessimistic and optimistic cash inflows, the more risky will be che project and vice versa. Which projet trill be accepted will solely depend upoa the atitude of the Investor or dession-maker towards risk. The sensitivity analysis ‘would disclose only the degree of risk asociated with a particule project. Limitation ‘Sensitivity analysis takes the effec of changes in one variable at aime fon the present value, This may be highly misleading. Tt assumes rable to be completely unrelated to each other which they re not It is only when the combined elfect of changes in the Set of inter-related variables is considered that we can get the right picture Example Smith Limited has onder consideration ewo mutually exclusive project for increasing its plant capacity. The management has Etveloped pessimist ertimates ofthe annual cash inflows associated ‘with each projet, The estimates are as fellows Mee of Prfiabiey April 238 Project Project Re. Re Init Investment 9,000 69,000 Cashinflow estimates Pessimine 2400 7400 Most Tkely 800 800 Optimise 14390 93900 You ate require (@) To calculate NPL. associted with cach estimate given for both the projects. The projects have 20 years lives each and the cort of capital is 10%. (b) Tosuggest which project should selected by the company. Solaion PAVE at 10% for 20 yeas (from Table B) comes to 8514. Hence, cach estimate has t0'be muliplied by 8514 for obtaining tor present values; oe Pee ca co fom _FV._NEV._tleve_Y_NBY. Se Bee ek mere Pesine 2409 TOUDAO- 95H 7400 GomDie + some Nowy et 1c appears that both the projects are eqully desirable on the tusis‘of most likly etmater of cuh inflows. However, the rence betwee Opinii and pesmi cash inflows (ad hence total PY) fe much lager Inthe case of Projet Land tence Project lis more risky than projet IL. This ean also be ‘buerved on the bass of N-PLV. which it postive in the cae Of Project IL der all etimates and hence Project Ils les faky. Ifthe company’s atu is to take risk. Project may be {Glved which i having the porsilry of giving mech higher mount of NV. a1 compared yo Project If the company follows 4 comervaive sttude towards rik, Project I shoul be sce.236 Enoepromrel Deepen {6 Decision Tueony Approach ‘The “decision tree” approach to an investment problem is application of the principle of “forward planning”- A. decisis ‘may be taken atthe present time by comparing various stern courses at present open to the decision maker, each alternaiy ‘arse being studied in the light ofthe future posible cond followed by fare alternative decisions. The family of ll dees present as well ab futurejviewed in relation to one another been elle the “decision tree”. The approach ie somewhat akin the ‘certainty equvalentco-ffcient approach asexplaned eae. ‘When the diferent posible evens are represented on a d a different paths, the diagram looks like 3 group of branchi ‘why the method is known as “decision "Thus, a decision tree analysin may be defined is [raphic display’ of the relationship beeween 2 present dec and fucute events, futute decisions and thee consequences. Sequence of events is mapped out over time in a format simi to the branches of 4 tee. ‘Step in Decton-tree analysis While constructing and using 2 decison tee the following ate to be considered 1) The investment proposal shoud frst of all be defined proposals might be sponsored by marketing, production o any other deparment. The proposal maybe t0 enter ‘new market or to produce a new prodsct. 2) Alternative decisions should be identified. For instance, i ‘concer is thinking of building a plant ro produce 2 new product, it may construct s large plant, a-medivm si plan, 2 small plant initlly and expand it later on oF ‘pon ‘rnoe the future demand willeontnue tae high r low: 3) The decison-tee should be graphed indicating the pints, chance events, and other. dats. 4) The revelant data such a the projected cath flows, pol Meshes of Prfahiny Appa 297 istrbutions, dhe expected presen value et. should be located ‘on the decision tee branches. 5) The results shouldbe analysed and the bes alternative should be selected