Decision Making Under Risk
Recall from Module 1 Background that in decision situations there are three different levels of uncertainty: assumed certainty, risk, and uncertainty. In SLP 1, we covered assumed certainty. In this Module we will discuss RISK. Recall what it means for a decision under risk:
Risk. In this situation, the decision maker distinguishes several possible future states, and is able to determine the probabilities of these distinct futures, or estimate the probabilities with a degree of confidence. There may be few or many options to choose from and the outcomes of these options may be different in the possible future states. For example, consider the weather which is always risky. And we usually have some estimates of the future states based on what the weatherman says. Two possible states are Rain and No Rain. The choices to consider here might be: Walk w/no umbrella, Walk w/umbrella, or Drive. The decision maker can determine the probabilities of Rain/No Rain from the forecast, for example, 60% chance of Rain (and 40% No Rain.) There are costs and payoffs involved with each option. And different people may have different decisions to make. The office employee may need to decide to walk or ride to work. The farmer may need to decide to work in the fields or protect the crops.
In all of these decisions there are basic elements that must be determined before the decision can be made. First, determine the possible future states (F) and the probabilities (p) for each. Note that the law of probability requires that the DM identify all a set of mutually exclusive and collectively exhaustive set of future states. And the probabilities must sum to 1.0 (100%). Then the DM must identify the alternatives (A). Note this is a key step as specified in Module 1. The next step is to identify the outcomes (O), payoffs, or consequences of each alternative for each future state. Quite often in business, this will be a monetary value. Then the DM can use the concept of Expected Value to determine the probability payoff for each alternative which allows for choosing the best alternative.
Review the following PowerPoint introducing decision making under risk:
Introduction to Decisions Under Risk (PPT) (Attached)
Now, watch this video that explains decision making under risk:http://permalink.fliqz.com/aspx/permalink.aspx?at=878629d1caf94d26b7e30bb857cbf6bf&a=5fae3cf0f1624f39b0341263a6541ea0
Download this Excel file that shows the example used in the video: SLP 2 Examples-Sample Problem.xlsx (Attached)
Try the Sample problem in this Excel file. Check your solution.
You should be ready for SLP 2.
Risk: Probabilities and Expected Value
Scenario: You work for a private investment company that currently has numerous business investments in real estate development, restaurant franchises, and retail chains. Following an exhaustive search for new investment opportunities, you have found three possible alternatives, each of which will pay off in exactly 10 years from the date of initial investment. Because you only have enough money to invest in one of the three options, you recognize that you will need to complete a quantitative comparison of the three alternatives:
Option A: Real estate development.
Option B: Investment in the retail franchise "Just Hats," a boutique that sells hats for men and women.
Option C: Investment in "Cupcakes and so forth," a franchise that sells a wide variety of cupcakes and a variety other desserts.
Download the raw data for the three investments in this Excel document: Raw data for BUS520 SLP 2 (Attached)
Develop an analysis of these three investments in Excel. Use expected value to determine which of the three alternatives you should choose.
Write a report to your private investment company, explaining your Excel analysis, giving your recommendation, and justifying your decision.
SLP Assignment Expectations
• Using Excel, make an accurate and complete analysis of the three investment alternatives.
• You must submit written discussion and analysis. This means that you should avoid use of tables and charts as "space fillers."
• Provide a brief introduction to/background of the problem.
• Discuss the steps you used in completion of your Excel analysis.
• Based on your Excel analysis, give your recommendation as to which of the three investment alternatives should be pursued.
We are seldom presented with business situations that are completely certain. Instead, we typically have risky decision-making circumstances, where we have some idea of the probability of occurrence of each outcome. Note that when making decisions under uncertainty, we don't know the probabilities of each outcome definitively. We may be estimating these probabilities, possibly unconsciously. In risky decision-making situations, it's easier to make decisions based on a single criterion; in business, that criterion is often monetary. We identify the outcome or payoff for each possible future or alternative, and the probability of its occurrence. We will use the expected value model to make decisions.
A good decision is not necessarily one where we achieve a good ...
An Excel file with the computations is shown. A Word file with a 466-word the report is given.