DECISION MAKING

WITH RISK AND

UNCERTAINTY
Definition
Uncertainty – occurs when there is insufficient information about what will happen, or what will
probably happen in future.
Risk – occurs when the future outcome from a decision could be any of several different
possibilities.
Reducing uncertainty
It can be reduced by obtaining more information on which some reliance can be placed.It is
uncertainty of volume of sales demand for a product: For established products estimates of
future sales can be, by taking historical sales figures and making adjustment for sales growth or
decline and planned changes in the sales price. New products –estimate of sales demand is
difficult as no benchmark exist on which to base. Uncertainty about future sales demand can be
reduced through market research.
Using probabilities: expected values
Expected values
These are widely used in decision making under uncertainty for analysing the information where
risk can be assessed in terms of probabilities of different outcomes. It is a weighted average of
all possible outcomes. It calculates the average return that will be made if a decision is repeated
again and again. Worth of a decision can be the expected value or weighted average of these
outcomes.
Expected values (EV) =weighted average of possible outcomes.
Cont…
In other words it is obtained by multiplying the value of each possible outcome (x) by the
probability of that outcome (p) and summing the results.
EV=SUMMATION PX
 Where p=the probability of each outcome
x= the value of each outcome
Example
Suppose a manager has to choose between mutually exclusive options A and B, and the probable
outcomes of each option are as follows.

Option A Option B
Probability Profit Probability Profit
0.8 5,000 0.1 (2,000)
0.2 6,000 0.2 5,000
0.6 7,000
0.1 8,000
Which project should be chosen?
Example 2
Division M is a division of MR plc. The following data relate to Division M.
Net assets $20m
Annual profit $5m
Cost of capital 15% per annum
MR plc is considering two proposals.
Proposal 1
Invest a further $2m in non-current assets to earn an annual profit of $0.40m.
Proposal 2
Dispose of non-current assets at their net book value of $5.5m. This would lead to profits falling by $1m per annum. Proceeds from
the disposal of these non-current assets would not be credited to Division M (but to the Holding Company of MR plc instead).
Required
(a) Calculate the current ROI and RI for Division M.
(b) Consider each of the two proposals and show how the ROI and RI would change if these proposals were adopted.
Advantages of expected values;
i)They take into account uncertainty by considering the probability of each possible outcome
and using this information to calculate an expected value.
ii) The information is reduced to a singular number resulting in easier decisions.
ii) The calculations are relatively simple.
Disadvantages

i) The probabilities used are usually very subjective.

ii) The expected value is merely a weighted average and therefore has little meaning for a one
off project.
ii) The expected values gives no indication of the dispersion of possible outcomes about the
expected values that the risk.
iv) The expected values may not correspond to any of the actual possible outcome.
End