ACCA SBL Syllabus G. Finance In Planning And Decision-Making - Risk and Strategy - Notes ^{8 / 11}

Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an investment project and the likelihood of each outcome occurring can therefore be quantified.

For example, based on past experience, a sales team may estimate it has a 60% chance of winning a particular contract

Expected Values (EV)

• The likelihood that an event will occur is known as its probability.   This is normally expressed in decimal form with a value between 0 and 1. 

  A value of 0 denotes a nil likelihood of occurrence whereas a value of 1 signifies absolute certainty. 

  A probability of 0.4 means that the event is expected to occur four times out of ten. 

  The total of the probabilities for events that can possibly occur must sum up to 1.0. 

  An expected value is computed by multiplying the value of each possible outcome by the probability of that outcome, and summing the results.

EV = ∑px

Where p = probability of the outcome
           x = the possible outcome

Advantages and disadvantages of EVs

• Advantages:

  1. Takes risk into account by considering the probability of each possible outcome and using this information to calculate an expected value.

  2. The information is reduced to a single number resulting in easier decisions.

  3. Calculations are relatively simple.

• Disadvantages:

  1. The probabilities used are usually very subjective

  2. The EV is merely a weighted average and therefore has little meaning for a one-off project

  3. The EV gives no indication of the dispersion of possible outcomes about the EV, i.e. the risk

  4. The EV may not correspond to any of the actual possible outcomes

Decision trees and Strategy decision problems

• • Large corporations have to handle uncertain future scenarios. 

    But, with things changing so quickly, plans need to be made for a variety of outcomes to remain competitive. 

    It might be better to rely on quantitative techniques to verify expertise and experience, rather than just "gut feeling"

  • Decision analysis techniques help companies solve complex problems, as well as evaluate a potential project’s financial value.

  • Decision trees allow for the probability of multiple scenarios and determine the potential impact of each. 

    This process gives a quantifiable value to the choices presented by future scenarios.

  • By quantifying the uncertainty, decision trees allow decision makers to model a variety of outcomes at multiple levels and react appropriately.

  • The process works by assigning probabilities based on managers’ experience and judgment. 

    When used as a strategic planning tool, decision trees can help to allocate resources and decide when to scale up or delay investment.

• For example (see above)

  a company estimates that next year’s demand for a new product has a 30% chance of being high, a 40% chance of being fair and a 30% chance of being low. 

  The product costs $3 million to bring to market. 

  Based on the costs associated with bringing the product to market, returns are positive in this scenario if the demand is high or fair, but negative if the demand is low.

  • In this example, the three scenarios result in a 30% chance of $7 million in cash flow, a 40% chance of $2 million and a 30% chance of $6 million. 

    Based on those probabilities, the project’s expected value is $1.1 million in positive cash flow.

    By calculating investment costs and comparing them to potential returns based on the likelihood of demand for the product, the company can pick the highest-value alternative. 

    Based on the alternatives in this scenario, the company should introduce their new product next year for a better chance of success.

    This example, while valid, is simplistic. In a real decision tree, most organizations would include several layers reflecting probabilities that explore a variety of “what ifs” for each choice. 

    While the example deals with a product launch, the same method can be used to explore the consequences and subconsequences of security investments intended to prevent terrorist attacks and the resulting costs. 

    It can also be applied to natural disasters or other failures.

    By assigning a quantifiable value to potential outcomes, decision trees help organisations make good decisions to navigate uncertain future scenarios.