Decision Analysis
Investment Decision
Things to think about
Decision factors:
1. What will the overall state of the economy be in the near future?
2. Which business sectors look most promising?
3. Which investments are most attractive?
4. What are current and near future government laws policies and regulations?
5. Simple example - which decisions will lead to the most profitable outcome?
Oil Mining Company
Your small Oil Drilling Company is evaluating a recent purchase of land for mining
operations.
Decision factors:
1. Should the company hire a geologist to obtain an independent evaluation
of the land?
2. How likely is it that oil is present in a location?
3. If gold is present, will there be enough to ensure a financial return?
Decision Analysis
Decision analysis tools provide a rational analysis and improve the evaluation of
your investment.
Select analysis tools include:
1. Maximax Criterion
2. Maximin Criterion
3. Equally likely Criterion
4. Expected Monetary Value (EMV)
5. Expected Value of Perfect Information (EVPI)
Uganda Oil Company believes from past experiences in the area that there might
be oil in a selected area.
Mining in the area will require a $80,000 initial investment. If there is no oil that
money will be lost, but if there is oil the company will make $600,000 profit.
A geologist is highered and a report says that is a 20% chance that there is oil in
the ground.
A big oil company has learned of the report and will buy the land creating an
$75,000 profit.
Decision Table
Oil No Oil
Mine the land $600,000 (-$80,000)
Sell Land $75000 $75,000
Probability 0.2 0.8
States of nature: Oil / No oil
Investment Decisions: Drill for oil or sell the land?
Terms
Alternatives:
Options available that include doing nothing, mining the land or selling the land.
States of Nature
Random factors outside the control of the decision maker that may influence the outcomes of the decision.
Probabilities
The relative likelihood of each possible state of nature. These may be obtained from secondary published
reports or research.
Payoff
Payoff or result is a quantitative result for each alternative investment option and state of nature
combination.
Maximax Criterion
What is the best that could happen?
Decisions Oil No Oil
Mine the $600,000 (-$80,000)
land Sell $75000 $75,000
Land
Maximax Criterion choose the highest payoff for each supply level. In this
case the company would choose to mine the land.
Maximin Criterion
Minimize ‘regret’ the opportunity loss for making the wrong decision.
Decisions Oil No Oil Minimum
Mine the $600,000 (-$80,000) (-$80,000)
land Sell $75000 $75,000 $75,000
What is the best payoff of the (worst) minimum outcomes?
Mine and have no oil (-$80,000)
Sell the land and receive $75,000.
The company would choose to sell the land.
Maximum Likelihood Criterion
Given the probabilities, which state of nature is most likely to occur?
Oil No Oil
Mine the land $600,000 (-$80,000)
Sell Land $75000 $75,000
Probability 0.2 0.8
Mine and have no oil (-$80,000) with 80% probability.
The company would choose to sell the land because the maximum likelihood
is that there is no oil.
Equally Likely Criterion
Using even probabilities and a weighted average what is the best payoff?
Oil No Oil EP
Mine the land $600,000 (0.5) (-$80,000) (0.5) $260,000
Sell Land $75000 (0.5) $75,000 (0.5) $75,000
Probability .5 .5
In this case the company would mine the land for oil.
Mine the land = $600,000 x 0.5 + (-80,000) x 0.5 = $260,000 > $75,000
Expected Monetary Value (EMV) w/o perfect information
Using given probabilities and a weighted average what is the best payoff?
Oil No Oil EMV
Mine the land $600,000 (0.2) (-$80,000) (0.8) $56,000
Sell Land $75000 (0.2) $75,000 (0.8) $75,000
Probability 0.2 0.8
We do not have perfect information. We have the probabilities from the
geologist. In this case the company would sell the land.
EVPI = Expected Value Under Certainty - Maximum EMV
Using even probabilities and a weighted average what is the best payoff?
Oil No Oil Max EMV
Mine the land $600,000 (0.2) (-$80,000) (0.8) $120,000
Sell Land $75000 (0.2) $75,000 (0.8) $60,000
Probability 0.2 0.8 $180,000
EVPI measures how much better could the decision-maker do if they knew
with certainty what state of nature would happen? If we knew there was oil
we would drill for oil. If we knew there was no oil we would sell the land.
EVPI = $180,000 - $75,000 = $105,000
Value of perfect information?
What are the benefits of perfect information?
Perfect information = EVPI (under certainty) minus EMV
EVPI = $180,000 - $75,000 = $105,000
Therefore, if they could hire someone that could provide ‘perfect’ information they
might be willing to pay up to $105,000 for the service. But, this is not likely
because this is not possible. Even the best geologist can’t be certain. In fact there
are many uncertainties. But, it is a benchmark parameter worth calculating.
Case #2
Choosing Materials for Manufacturing
Scenario
A fashion designer wants to produce a new line of clothes. In the
production of the clothes, expensive, medium-priced, or inexpensive
materials can be used. The profits associated with each type of material
depend on the economic conditions next year. The payoff table (matrix) is
on the next slide.
An economist believes that the probability that the economy will improve is
20%, the probability that the economy will stay the same is 70%, and the
economy will decline is 10%. Only a fortune teller knows what will happen
next year. How much are you willing to pay for her information?
Decision Criteria from case
Economy staying the Economy
Materials Economy Improving
same Declining
Expensive $80,000 $40,000 $10,000
Medium $40,000 $60,000 $70,000
Inexpensive $10,000 $30,000 $60,000
Probability 0.2 0.7 0.1
Making something
Given the following inputs how might you calculate the
Select analysis tools include:
1. Maximax Criterion
2. Maximin Criterion
3. Equally likely Criterion
4. Expected Monetary Value (EMV)
5. Expected Value of Perfect Information (EVPI)
Maximax Criterion
What is the best that could happen? No probabilities are used.
Economy Economy Economy
Materials
Improving staying the same Declining
Expensive $80,000 $40,000 $10,000
Medium $40,000 $60,000 $70,000
Inexpensive $10,000 $30,000 $60,000
What is the best option without probabilities if the economy improves, stay the
same, or declines what is the best option? The best is $80,000 if the
economy improves.
Maximum Likelihood Criterion
Given the probabilities, which state of nature is most likely to occur?
Economy Economy Economy
Materials Improving staying the same Declining
Expensive $80,000 $40,000 $10,000
Medium $40,000 $60,000 $70,000
Inexpensive $10,000 $30,000 $60,000
Probability 0.2 0.7 0.1
Equally Likely Criterion
Using even probabilities and a weighted average what is the best payoff?
Economy Economy Equally likely
Materials staying the
Improving Declining outcomes
Expensive $80,000 $40,000 $10,000 $42,900
Medium $40,000 $60,000 $70,000 $56,100
Inexpensive $10,000 $30,000 $60,000 $33,000
Probability .33 0.33 0..33
If economic changes are equally likely, then medium materials would be
chosen.
Expected Monetary Value (EMV) w/o perfect information
Using even probabilities and a weighted average what is the best payoff?
Economy Economy staying Economy
Materials EMV
Improving the same Declining
Expensive $80,000 $40,000 $10,000 $45,000
Medium $40,000 $60,000 $70,000 $57,000
Inexpensive $10,000 $30,000 $60,000 $29,000
Probability 0.2 0.7 0.1
Without any additional information the designer should use medium materials.
Expected Value Under Perfect Information (EVPI)
Using even probabilities and a weighted average what is the best payoff?
Economy Economy Economy
Materials
Improving staying the same Declining
Expensive $80,000 $40,000 $10,000
Medium $40,000 $60,000 $70,000
Inexpensive $10,000 $30,000 $60,000
Probability 0.2 0.7 0.1
EVPI = $80,000 x (0.2) + $60,000 x 0.7 + $70,000 x 0.1 = $65,000
Therefore, without the fortune teller we know this outcome.
How much would you pay the fortune teller?
Well, without the fortune teller we were able to calculate the EMV of $57,000.
With the fortune tellers perfect information we calculated EVPI of $65,000.
Therefore, the fashion designer would be willing to pay the fortune teller for their
information not more than $8,000.
$65,000
$57,000
$8,000
