Probability analysis

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Probability analysis

This gives potential outcomes a probability

These probabilities are then used to calculate an expected net present value (ENPV)

Calculating an ENPV

Formula

  • ∑px

    P = probability and X = Value of outcome

    It finds the the long run average outcome rather than the most likely outcome

Illustration

A new product cashflows will depend on whether a substitute comes onto the market or not

  • Chance of substitute coming in 30% - this will lead to a loss of  (10,000)

    NPV with no substitute though is 20,000

  • Solution

    Subsitute does come in = 0.3 x (10,000) = (3,000)
    Subsitute does NOT come in =0.7 x 20,000 = 14,000

    ENPV = 11,000

Limitations of Probability Analysis

Expected values are more useful for repeat decisions rather than one-off activities, as they are based on averages.

They illustrate what the average outcome would be if an activity was repeated a large number of times. 

A long term rather than short term average

  • For example the expected value when throwing a dice is 3.5! 

    And the average family in the UK has 2.4 children, now I've never thrown a 3.5 nor met anyone with 2.4 children.

    These are just long term averages, whereas in reality outcomes only occur once

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