5 Expected value (EVs) in decision making 5.1 Expected values
When considering a scenario it may be possible to make several predictions about alternative future outcomes and to assign probabilities to each outcome.
An expected value is computed by multiplying the value of each possible outcome by the probability of that outcome, and summing the results.
An expected value can therefore be defined as a weighted average value, calculated from probability estimates.
Illustration 7 – EVs in decision making
Cash flows from a new restaurant venture may depend on whether a competitor decides to open up in the same area. We make the following estimates:
Competitor opens upProbabilityProject NPVEV
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Yes0.3(10,000)(3,000)
No0.720,00014,000
11,000
The expected NPV of this venture is (0.3 × -10,000) + (0.7 × 20,000) = $11,000.
The simple decision rules using EVs are:
§ to accept projects with a positive expected NPV as above.
§ when choosing between projects accept those projects with the highest expected NPVs.
A matrix can be a useful way to represent and analyse a scenario where there is a range of possible outcomes and a variety of possible responses.
Advantages of EVs
§ Recognises that there are several possible outcomes and is, therefore, more sophisticated than single value forecasts.
§ Enables the probability of the different outcomes to be quantified.
§ Calculations are relatively simple.
Limitations of EVs
§ By asking for a series of forecasts the whole forecasting procedure is complicated. Inaccurate forecasting is already a major weakness in project evaluation. The probabilities used are also usually very subjective.
§ The EV is merely a weighted average of the probability distribution, indicating the average pay-off if the project is repeated many times. This has little meaning for a one-off project.
§ The EV gives no indication of the dispersion of possible outcomes about the EV. The more widely spread out the possible results are, the more risky the investment is usually seen to be. The EV ignores this aspect of the probability distribution. In the above example, the EV is positive but there is still a 30% chance of making a loss.
§ In ignoring risk, the EVT also ignores the investor’s attitude to risk. Some investors are more likely to take risks than others.
Conclusions on EVs
The simple EV decision rule is appropriate if three conditions are met or nearly met:
§ There is a reasonable basis for making the forecasts and estimating the probability of different outcomes.
§ The decision is relatively small in relation to the business. Risk is then small in magnitude.
§ The decision is for a category of decisions that are often made. A technique which maximises average pay-off then valid. |
发表于 2012-2-23 17:09:42
