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Uncertainty and Capital BudgetingACCT 7320, 11/19/14, Bailey

This presentation contains two parts:– A general model of decision-making under

uncertainty, using “expected value”– Discussion of “Using Decision Trees to

Manage Capital Budgeting Risk,” J. Bailes & J. Nielsen, Management Accounting Quarterly, Winter 2001

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Decision Models and Uncertainty

Managers frequently must deal with uncertainty.

The model presented here represents a rational approach to decision making under uncertainty, assuming you are risk-neutral.

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Decision Model Assumptions

Choice Criterion Set of Alternatives (Actions to consider)

Mutually exclusive, Exhaustive Set of Events (States of Nature) Set of Probabilities associated with the events Set of Outcomes (Income, cost, etc., to

minimize or maximize)

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Example of DM under Uncertainty

Action Taken Buy new Eqpt Keep old

EqptE Get Govt Income = Income =v Contract $500,000 $300,000e n Not get Govt Income = Income =t Contract $10,000 $200,000 Which action is best?

Depends on probabilities we assign to the events.

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Decision Models and Uncertainty

EV=Σ (Outcomei) (Pi) i.e., summation of each outcome (in this case, income) times the probability of that outcome.

Suppose P(getting contract) = .20 [read as “probability of getting contract = .20”]

Thus P(not getting contract) = .80. EV(buying new Eqpt) = $500,000*.20 + $10,000*.80 = $108,000

EV(keeping old Eqpt) = $300,000*.20 + $200,000*.80 = $220,000 To maximize expected value, we keep old equipment.

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Forest Product Companies and Timberland

Long-term capital-budgeting decisions– More risk– Time value of money especially important

Typical decision:– Buy timberland now, or– Buy timber as needed

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The basic decision

Starting point in hypothetical case assumes indifference given the current regulatory environment, for simplicity only.

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Expected Values of the Two Actions

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Uncertainty: Regulatory environment may change

Difference in these two columns is NPV of buying now

Difference in these two columns is NPV of buying as needed.

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Possible Regulatory Environments and Related Outcomes

$6.5-7.0

$4.5-3

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The End