Chapter V
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Nesri YayaChapter V
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Nesri YayaChapter 5
Risk and uncertainty Analysis
Conditions:
The techniques of project analysis have been
considered so far as if the basic data which
they have used are known with certainty.
However, both technical and economic
information is used in the form of forecasts
and is subject to considerable uncertainty.
Risk and Uncertainty
• Risk
• Situation where there is more than one possible
outcome to a decision and the probability of
each outcome is known
• Uncertainty
• Situation where there is more than one possible
outcome to a decision and the probability of
each outcome is unknown
• In decision making involving risk or
uncertainty the three terms are quite often
used. They are:
1) Strategy,
2) State of nature,
3) Outcome.
Strategy
• A strategy refers to one of several alternative courses of
action or plans that can be implemented to achieve the
desired goal.
• For example, a manager may be considering the following
three strategies aimed at increasing profits of the firm:
• Building a new technologically more efficient plant
so as to reduce the cost of production
• Launching of a new advertising and marketing
complain to increase sales
• Redesigning of the product so as to lower the cost of
production and to increase in demand for it by getting
greater consumer acceptance.
A state of nature
• A state of nature refers to the conditions that
prevail in future and which have a significant
effect on the success or failure of the strategy.
• For example, in case of building a
technologically superior plant the different
states of nature that may exist in some future
years are a) boom, b) recession, c) normal
conditions.
• Outcome refersOutcome
to the results which are
usually in the form of profit that come about
as a result of implementation of a strategy. A
payoff matrix lists the outcomes associated
with combinations of each strategy and state
of nature.
• It is important to note that risk refers to the
amount of variability in the outcome as a
result of the adoption of a particular strategy.
Measuring Risk: Probability Distributions
• Probability
• Chance that an event will occur
• Probability Distribution
• List of all possible events and the
probability that each will occur
• Expected Value or Expected Profit
n
E ( ) i Pi
i 1
Calculation of Expected Profit
State of Probability Outcome Expected
Project Economy (P) () Value
Boom 0.25 $600 $150
Normal 0.50 500 250
A
Recession 0.25 400 100
Expected profit from Project A $500
Boom 0.25 $800 $200
Normal 0.50 500 250
B
Recession 0.25 200 50
Expected profit from Project B $500
• Discrete Probability Distribution
• List of individual events and their
probabilities
• Represented by a bar chart or histogram
• Continuous Probability Distribution
• Continuous range of events and their
probabilities
• Represented by a smooth curve
Discrete Probability Distributions
Project A; E(p) = 500, Low Risk Project B: E(p) = 500, High Risk
Continuous Probability Distributions
Project A: E(p) = 500, Low Risk Project B: E(p) = 500, High Risk
An Absolute Measure of Risk:
The Standard Deviation
n
(X
i 1
i
2
X ) Pi
Calculation of the Standard Deviation
Project A
(600 500) 2 (0.25) (500 500)2 (0.50) (400 500) 2 (0.25)
5, 000 $70.71
Calculation of the Standard Deviation
Project B
(800 500) 2 (0.25) (500 500)2 (0.50) (200 500)2 (0.25)
45, 000 $212.13
A Relative Measure of Risk:
The Coefficient of Variation
v
Project A Project B
70.71 212.13
vA 0.14 vB 0.42
500 500
Three decision approaches
• Maximax - Risk Seeking
• Prefer to take on risk
• Maximize the best possible outcome
• Maximin- Risk Averse
• Must be compensated for taking on risk
• Maximize the worst possible outcome
• Minimax regret- Risk Neutral
• Are indifferent to risk
• Minimize the maximum opportunity cost
Example:
• Say I own land that might contain oil.
• Value of land – 5 million
• Drill for oil – 12 million
• Find oil – 40 million
• Find no oil – 3 million
• Decision: sell or drill?
Required:
• Prepare pay off table
• Make a decision based on:
• Expected value/probability distribution/
• Maximax approach/best case scenario/
• Maximin approach /best worst case scenario/
• Minimax regret approach/opp. cost approach/
Pay off table
Oil Dry
Drill 40-12 =28 3-12= -9
Sell 5 5
Decision based on expected value
If chance of finding oil is 0.6
Oil Dry EV
Drill 28 -9 13.2
Sell 5 5 5
Prob. 0.6 0.4
Decision: EV of drill = 13.2 which is greater than
EV of Sell = 5. Therefore, the decision is to drill.
Decision based on Maximax approach
For every decision, find the best outcome
Oil Dry Max
Drill 28 -9 28
Sell 5 5 5
Max 28
Decision: since the maximum outcome is 28,
the decision is to drill.
Decision based on maximin approach
For every decision, find the best outcome
Oil Dry Min
Drill 28 -9 -9
Sell 5 5 5
Max 5
Decision: since the maximin outcome is 5, the
decision is to sell.
Decision based on minimax regret approach
For every decision, find the opportunity cost
Oil Dry Oil Dry Max
regret regret regret
Drill 28 -9 0 14 14
Sell 5 5 23 0 23
Min 14
Decision: since the Minimax regret is 14, the
decision is to drill.
Adjusting Value for Risk
n
t
Firm=Net Present
• Value of theNPV t Value
t 1 (1 r )
• kRisk-Adjusted Discount Rate tn
r Risk Premium NPV
t 1 (1 k )t
Adjusting Value for Risk
n
Rt
NPV Approach
• Certainty Equivalent t
t 1 (1 r )
equivalent certain sum Rt*
• Certaintyexpected
Equivalent
riskyCoefficient
sum Rt
Other Techniques
• Decision Trees
• Sequence of possible managerial
decisions and their expected outcomes
• Conditional probabilities
• Simulation
• Sensitivity analysis
Outcome Expected
Decision tree State of nature
Estimated profit profits
ma n d [0.25]
High de 250,000 250,000 X 0.25
= 62,500
A 2
ct
o je
pr
Low d
e mand -30,000 X 0.75
ge
[0 .75]
lar
- 30,000 = -22,500
a
tin
E(R) = 40,000
esv
In
1 25] 120,000 120,000 X 0.25
[0.
and = 30,000
Inv h d em
est
in Hig
a sm
all p
roje 2
ct B
Low =20,000 X 0.75
d ema
nd [ = - 15,000
0.75
]
- 20,000
E(R) = 15,000
