Compiled by CA.

nirmal shrestha Risk & Uncertainty

CHAPTER 6
RISK & UNCERTAINTY

INTRODUCTION
Decision making, particularly long-term decisions, has to be taken under the conditions of risk and
uncertainty

WHAT IS RISK AND UNCERTAINTY?

Uncertainty
Uncertainty simply reflects that there is more than one possible outcome for a given event but there is little
previous statistical evidence to enable the possible outcomes to be predicted.

Risk
Risk is where that uncertainty can be quantified in some way.
It is normal to quantify the risk in terms of a probability distribution, generally derived from statistical data
in the past.

Risk attitudes
Risk preference describes the attitude of a decision-maker toward risk – as there is a relationship between
risk and reward.
 Risk averse – a risk averse decision-maker considers risk in making decision, and will not select a
course of action that is riskier unless the expected return is higher and so justifies the extra risk.
 Risk seeker – a risk seeker decision-maker also considers risk in making a decision.
A risk seeker, unlike a risk averse decision-maker, will take extra risks in the hope of earning a higher
return.
 Risk neutral – a risk neutral decision-maker makes trade-off between risk and return.

MARKET RESEARCH
Market research is a process of systematically and objectively gathering, recording and analysing
information. This information may relate to:
 customers;
 general trends in the market;
 competitors;
 government regulations;
 economic trends;
 technological advancements; and
 any other factors that constitute the business environment

Worst, most likely, and best outcome estimates

The choice between two or more alternative courses of action might be based on the worst, most likely or
best expected outcomes from each course of action. This choice will show the full range of possible
outcomes from a decision, and might help managers to reject certain alternatives because the worst possible
outcome might involve an unacceptable amount of loss.
This requires the presentation of a pay-off table.

Pay-off table (or matrix)

The pay-off matrix is a tabular layout specifying the result (pay-off) of each combination of decision and
the state of the world over which the decision maker has no control.

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Example 1: Won Ltd is trying to decide the selling price for a product. Three prices are under
consideration and expected sales volume and costs are as follows:
Price per unit £4 £4.30 £4.40
Expected sale volume (unit)
Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000
Fixed costs are £20,000 and variable cost is £2 per unit.
Required:
Which price should be chosen?
Hints: Best Possible = £4.30 (contribution £32,200); Most Likely = £4.40 (Contribution £28,800);
Worst Possible = £4 (contribution £20,000)

EXPECTED VALUE
The expected value ignores the degree of risk and focuses solely on the average return of the event given
repetition of the event.

Probability
The measurement of the outcomes in terms of their estimated likelihood of occurring.
Overall probability of an event must sum to 1.0 (or if you wish 100%). For example, if you toss a coin there
is a 0.5 (50%) probability of a head or a tail. Adding both outcomes total 1.0 (100%).

Expected values
A weighted average value of all the possible outcomes. It does not reflect the degree of risk, but simply
what the average outcome would be if the event were repeated a number of times.
A decision rule is to select the course of action with the highest expected value of profit or the lowest
expected value of cost.
Expected value formula
EV = ∑px
P = probability of an outcome
x = value of an outcome
Example 2: D Ltd expects the following monthly profits:
Monthly profit Probability
£50,000 0.6
£35,000 0.4
Required:
Calculate the expected value of monthly profit.
Hints: £44,000
Example 3: Consider the following sales and probabilities.
Sale probabilities
£ %
20,000 25
25,000 40
30,000 15
35,000 20
Required:
What will be the expected value?
Hints: £26,500

Advantages of expected values

1. EV considers all the different possible outcomes and the probability that each will occur.

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2. It recognises risk in decision, based on the probabilities of different possible results or outcomes.
3. It expresses risk as a single figure.

Limitations of expected values

1. The EV shows a long term average, so that the EV will not be reached in the short term and is therefore
not very suitable for one-off decisions.
2. The accuracy of the results depends on the accuracy of the probability distribution used.
3. EV takes no account of the risk associated with a decision.

DECISION CRITERIA
Choosing between mutually exclusive courses of action on the basis of worst, most likely or best possible
outcome can be stated as decision rules.
The choice may be based on a maximax, maximin, or a minimax regret decision rule, and expected value.

Maximax
The decision maker will select the course of action with the highest possible payoff (the best of the best).
The maximax decision rule is the decision rule for the risk seeker.
Maximize the maximum achievable profit.

Maximin decision rule

The decision maker will select the course of action with the highest expected return under the worst possible
conditions. This decision rule might be associated with a risk averse decision maker.
Maximize the minimum achievable profit.

Minimax regret decision rule

The decision maker selects the course of action with the lowest possible regret. It aims at minimizing the
regret from making the wrong decision.
Regret is the opportunity cost of having made the wrong decision, giving the actual conditions that apply
in the future.
Example 4: Too Ltd is trying to decide which of the three mutually exclusive projects to undertake. The
company has constructed the following payoff table or matrix.
Net profit if outcome turns out to be Worst Most likely Best
Project A 50 85 130
Project B 70 75 140
Project C 90 100 110
Required:
State which project would be selected using each of the:
(a) maxmin;
(b) maximax criteria; and
(c) minimax regret rule.
Hints: (a) maxmin = Project C (90) ; (b) maximax criteria = Project B (140); (c) minimax regret
rule = project B(25)
Example 5: Mr Fyvestall runs a market stall selling vegetables and fruit. He buys a product for £20 per
case. He can sell the product for £40 per case on his stall. The product is perishable, and it is not possible
to store it, instead any cases unsold at the end of the day can be sold off as scrap for £2 per case.
Purchase orders must be made before the number of sales is known. He has kept records of demand over
the last 150 days.
Demand / day Number of days
10 45
20 75
30 30

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Required:
(a) Prepare a summary of possible net daily margins using a payoff table.
(b) Advise Mr Fyvestall:
(i) How many cases to purchase if he uses expected values.
(ii) How many cases to purchase if he uses maximin / maximax.
(iii) How many cases to purchase if he uses minimax regret.
Hints: (b) (i) EV = £286 per day so buy 20 ; (b) (ii) Maximin buy 10, Maximax buy 30; (b) (iii) Minimax
regret buy 20

DECISION TREE ANALYSIS

A decision tree is a diagram showing several possible courses of action and possible events and the potential
outcomes for each course of action.
Each alternative course of action is represented by a branch, which leads to subsidiary branches for further
course of action or possible events.
Decision tree analysis is designed to illustrate the full range of alternatives that can occur, under all possible
given conditions.
The financial outcomes and probabilities are shown separately, and the decision tree is ‘rolled back’ by
calculating expected values and making decisions

Three step method

Step 1: Draw the tree from left to right, showing appropriate decisions and events / outcomes.
Step2: Evaluate the tree from right to left carrying out these two actions:
(a) Calculate an EV at each outcome point.
(b) Choose the best option at each decision point.
Step 3: Recommend a course of action to management.

Example 6: Beethoven Co has a new wonder product, the vylin, of which it expects great things. At the
moment the company has two courses of action open to it, to test market the product or abandon it.
If the company test markets it, the cost will be $100,000 and the market response could be positive or
negative with probabilities of 0.60 and 0.40.
If the response is positive the company could either abandon the product or market it full scale.
If it markets the vylin full scale, the outcome might be low, medium or high demand, and the respective
net gains (losses) would be (200), 200 or 1,000 in units of $1,000 (the result could range from a net loss
of $200,000 to a gain of $1,000,000). These outcomes have probabilities of 0.20, 0.50 and 0.30
respectively.
If the result of the test marketing is negative and the company goes ahead and markets the product,
estimated losses would be $600,000.
If, at any point, the company abandons the product, there would be a net gain of $50,000 from the sale
of scrap. All the financial values have been discounted to the present.
Required
(a) Draw a decision tree.
(b) Include figures for cost, loss or profit on the appropriate branches of the tree.
Hints: The choice would be to test market the product, because it has a higher EV of profit i.e. $136,000.
Example 7: The 'Duke of York' is an independent cinema in Brightville. It is considering whether or not
to hire a movie to show in its cinema for one week. If the management decides to hire the movie, it will
be screened 20 times during the week. The cost of hiring the movie for the week is $70,000.
You work as the cinema's accountant, and you have been asked to evaluate the financial effects of the
decision to hire the movie. You have made the following estimates:
(1) Customers

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The entrance fee for every customer is $10. The number of customers watching the movie at each
screening is uncertain, but has been estimated as follows: there is a 50% probability 200 customers will
attend the screening; a 30% probability 250 customers will attend, and 20% probability 150 customers
will come.
(2) Customer contribution for each sale of refreshments
The average contribution per customer earned from the sale of refreshments is also uncertain but has
been estimated as follows:
Probability $ average contribution per customer
40% probability $10 per customer
25% probability $12 per customer
35% probability $8 per customer
Required:
Prepare a decision tree to show the total contributions which could be generated from the above scenario.
Based on the expected values, determine if the movie should be hired.
Hints: At the first and only decision point in our tree, we should choose the option to hire the movie as
EV equal to a positive contribution of $11,180 and not hiring the movie does not generate any
contribution at all.

VALUE OF PERFECT INFORMATION (VPI)

If perfect information about the future were available, it would be very easy to make a decision as the
uncertainty and risk associated with it would be minimum.
Therefore, knowledge about cost of obtaining the perfect information is very important for management
point of view.
The price that one would be willing to pay in order to gain access to perfect information of an uncertain
outcome in decision making is known as Value of Perfect Information.
Mathematically VPI is the difference between the payoff under certainty and the payoff under risk.
Example 8: A company wishes to go ahead with one of three mutually exclusive projects, but the profit
outcome from each project will depend on the strength of sales demand, as follows.
Strong demand Moderate demand Weak demand
Profit/(Loss) Profit Profit/(Loss)
$ $ $
Project 1 70,000 10,000 (7,000)
Project 2 25,000 12,000 5,000
Project 3 50,000 20,000 (6,000)
Probability of demand 0.1 0.4 0.5
What is the value to the company of obtaining this perfect market research information, ignoring the cost
of obtaining the information?
Hints: EV of Project 1 = $7,500; EV of Project 2 = $9,800; EV of Project 3 = $10,000
Value of perfect information = $7,500 – ignoring the cost of obtaining the information.
Example 9: A company wishes to go ahead with one of two mutually exclusive projects, but the profit
outcome from each project will depend on the strength of sales demand, as follows.
Strong demand Moderate demand Weak demand
Profit Profit Profit/(Loss)
$ $ $
Project 1 80,000 50,000 (5,000)
Project 2 60,000 25,000 10,000
Probability of demand 0.2 0.4 0.4
The company could purchase market research information, at a cost of $4,500. This would predict
demand conditions with perfect accuracy.
What is the value to the company of obtaining this perfect market research information?
Hints: Value of perfect information = $1,500

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The value of imperfect information
In practice, information is never perfect. Market research findings or information from pilot tests and so on
are likely to be reasonably accurate, but they can still be wrong: they provide imperfect information. It is
possible, however, to arrive at an assessment of how much it would be worth paying for such imperfect
information, given that we have a rough indication of how right or wrong it is likely to be.
The value of imperfect information is the difference between the EV of profit with imperfect information
and the EV of profit without the information.
Example 10: Suppose that a company want to make a decision between two mutually exclusive options,
Option A and Option B. The profits from each option will depend on the state of the economy in the next
12 months.
Current estimates are that there is a 60% probability that the economy will be weak and a 40%
probability that the economy will be strong.
The profitability with each decision option would be as follows.
Option A Option B
Weak economy + $50,000 + $20,000
Strong economy + $60,000 + $100,000
Research could be carried out into the state of the economy in the next 12 months. It has been estimated
that if the true state of the economy will be weak, there is an 80% probability that the research would
predict this correctly. It is also estimated that if the true state of the economy will be strong, there is a
90% probability that the research would predict this correctly.
What is the value of this imperfect information?
Hints: Value of decision without information is to select Option A and the EV of profit would be $54,000.
Value of decision with imperfect information $64,800. Value of the imperfect information = $10,800.

SENSITIVITY ANALYSIS
Sensitivity analysis is a method of risk or uncertainty analysis in which the effect on the expected outcome
of the change in values of key variables or key factors is tested. For example, in budget planning, the effect
on budgeted profit might be tested for changes in the budgeted sales volume, or the budgeted sale price,
material and labour costs, and so on.

There are several ways of using sensitivity analysis including:

 To estimate by how much costs and revenues would need to differ from their estimated values before
the decision would change.
 To estimate whether a decision would change if estimated sales were A% lower than estimated, or
estimated costs were B% higher than estimated. This is called ‘what if’ analysis. For example: what if
the sales volume is 5% less than the expected volume?
Example 10: A company is considering launching a new product in the market. Profit estimates are as
follows:
$ $
Sales (10,000 units) 200,000
Variable costs:
Materials 120,000
Labour 20,000
140,000
Contribution 60,000
Fixed costs (all directly attributable) 50,000
Profit 10,000
The estimates of sales volume, sales price, variable costs and fixed costs are uncertain.
Sensitivity analysis can be used to calculate the extent to which the profitability of the product depends
on the accuracy of the estimates. We can calculate by how much each of these variables would have to
be ‘worse’ than estimated before the product became loss-making.

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Profit can fall by $10,000 before the product ceases to be profitable. Profit would fall by $10,000 if:
 sales volume is $10,000/$60,000 = 16.7% less than expected: this is because each 1% fall in
sales volume will reduce contribution by 1%
 the sales price is $10,000/$200,000 = 5% less than expected
 material costs are $10,000/$120,000 = 8.3% more than expected
 labour costs are $10,000/$20,000 = 50% more than expected
 fixed costs are $10,000/$50,000 = 20% more than expected.

Advantages
1. It is not a complicated theory to understand
2. It forces managers to identify the underlying variables, indicate where additional information would be
most useful, and helps to expose confused and inappropriate forecasts
3. An indication is provided of those variables to which profitability or value is most sensitive. And the
extent to which those variables may change before the investment break-even.
4. It provides an indication of why a project might fail. Once these critical variables have been identified,
management should review them to assess whether or not there is a strong possibility of events occurring
which will lead to a negative NPV.
5. It serves as an aid in the preparation of contingency plans, should key parameters show unfavorable
variations ex-post.

Disadvantages
1. The method requires that changes in each key variable are isolated. But management is more interested
in the combination of the effects of changes in two or more variables.
2. It does not examine the probability that any particular variation in cost or revenue might occur.
3. It is not in itself a decision rule. Management must weigh the information provided by the analysis in
deciding whether the investment is worthwhile.

SIMULATION
Simulation is a quantitative technique that uses IT based computerized packages with built in mathematical
models for decision making under conditions of uncertainty. It evaluates various courses of action based
upon facts and assumptions.
Monte Carlo is a widely used method of simulation, where complex problem is solved by simulating the
original data with random number generators.
Usefulness of simulation:
 Medical diagnosis
 Gambling
 Air force trainings
 Traffic scheduling.

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