Riskin Project Analysis

Managerial Economics
RISK IN PROJECT ANALYSIS

Risk vs. Uncertainty

• Risk
• Must make a decision for which the
outcome is not known with certainty
• Can list all possible outcomes & assign
probabilities to the outcomes
• Uncertainty
• Cannot list all possible outcomes
• Cannot assign probabilities to the
outcomes
Expected Utility Theory

• Actual decisions made depend on
the willingness to accept risk
• Expected utility theory allows for
different attitudes toward risk-
taking in decision making
• Managers are assumed to derive
utility from earning profits
Expected Utility Theory

• Managers make risky decisions in a
way that maximizes expected utility
of the profit outcomes
E [U (  )]  p1U(  1 )  p2U (  2 )  ...  pnU (  n )
• Utility function measures utility

associated with a particular level of
profit
• Index to measure level of utility received
for a given amount of earned profit
Manager’s Attitude Toward Risk
• Determined by manager’s marginal

utility of profit:
MU profit  U (  ) 
• Marginal utility (slope of utility

curve) determines attitude toward
risk

• Risk-averse
• If faced with two risky decisions with
equal expected profits, the less risky
decision is chosen
• Risk loving/seeker
• Expected profits are equal & the more
risky decision is chosen
• Risk-neutral
• Indifferent between risky decisions
that have equal expected profit
• Can relate to marginal utility of

profit
• Diminishing MUprofit
• Risk averse
• Increasing MUprofit
• Risk loving
• Constant MUprofit
• Risk neutral
(Figure 15.5)
(Figure 15.5)
(Figure 15.5)
Measuring Risk with Probability
Distributions
• Table or graph showing all
possible outcomes/payoffs for a
decision & the probability each
outcome will occur
• To measure risk associated with a
decision
• Examine statistical characteristics of
the probability distribution of
outcomes for the decision
15-11
Probability Distribution for Sales
(Figure 15.1)
15-12
Expected Value
• Expected value (or mean) of a
probability distribution is:
n
E( X )  Expected value of X   pi X i
i 1
Where Xi is the ith outcome of a decision,

pi is the probability of the ith outcome, and
n is the total number of possible outcomes
15-13
Expected Value
• Does not give actual value of the
random outcome
• Indicates “average” value of the
outcomes if the risky decision were to
be repeated a large number of times
15-14
Variance
• Variance is a measure of absolute risk
• Measures dispersion of the outcomes about the mean
or expected outcome
n
Variance(X)     pi ( X i  E( X ))
2
x
2
i 1
• The higher the variance, the greater

the risk associated with a probability
distribution
15-15
Identical Means but Different
Variances (Figure 15.2)
15-16
Standard Deviation
• Standard deviation is the square
root of the variance
 x  Variance(X)
• The higher the standard deviation,

the greater the risk
15-17
Probability Distributions with
Different Variances (Figure 15.3)
15-18
Coefficient of Variation
• When expected values of outcomes
differ substantially, managers should
measure riskiness of a decision relative
to its expected value using the
coefficient of variation
• A measure of relative risk
Standard deviation 
 
Expected value E( X )
15-19
Decisions Under Risk

• No single decision rule guarantees
profits will actually be maximized
• Decision rules do not eliminate risk
• Provide a method to systematically
include risk in the decision making
process
15-20
Summary of Decision Rules
Under Conditions of Risk
Expected Choose decision with highest expected value
value rule
Mean- Given two risky decisions A & B:
variance •If A has higher expected outcome & lower
rules variance than B, choose decision A
•If A & B have identical variances (or standard
deviations), choose decision with higher
expected value
•If A & B have identical expected values,
choose decision with lower variance (standard
deviation)
Coefficient of Choose decision with smallest coefficient of
variation rule variation
15-21
Probability Distributions for
Weekly Profit (Figure 15.4)
E(X) = 3,500 A E(X) = 3,750 B
= 1,025 = = 1,545 =
0.29 0.41
E(X) = 3,500 C
= 2,062 =
0.59
15-22
Which Rule is Best?

• For a repeated decision, with
identical probabilities each time
• Expected value rule is most reliable to
maximizing (expected) profit
• Average return of a given risky course
of action repeated many times
approaches the expected value of that
action
15-23
Which Rule is Best?

• For a one-time decision under risk
• No repetitions to “average out” a bad
outcome
• No best rule to follow
• Rules should be used to help
analyze & guide decision making
process
• As much art as science
15-24

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Managerial Economics

RISK IN PROJECT ANALYSIS

Risk vs. Uncertainty

Expected Utility Theory

Expected Utility Theory

• Utility function measures utility

Manager’s Attitude Toward Risk

• Determined by manager’s marginal

• Marginal utility (slope of utility

Manager’s Attitude Toward Risk

Manager’s Attitude Toward Risk

• Can relate to marginal utility of

Where Xi is the ith outcome of a decision,

• The higher the variance, the greater

• The higher the standard deviation,

Decisions Under Risk

Which Rule is Best?

Which Rule is Best?

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