MANAGEMENT AND
CORPORATE ECONOMICS
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1
Introduction
• To meet the requirements
– Midterms after our classes
– Material: all slides, explanations  on the web (M&BE)
– The midterm has two parts
• ‘Basics’ part: 20 minutes
• Comprehensive part: 20-25 minutes, essay
– Taking the midterm is compulsory for everyone
– Final grade: sum of the 4 midterms
– In case someone misses or fails: it is possible to retake 2 of
the 4 midterms during the semester
3
Introduction
• The aim of the class
• Management
– Roles of the management
– Functioning and attributes of different types of
organizations
– Organizational issues
– Quality management, mgm. of production processes
• The financial part
– Corporate economics (business and public economics)
• Corporate goals, background (e.g. corporate decision making)
• Closer to the production and service providing processes
– Notions that we use: revenue, costs, profit
– Economics of a business activity
• Investment and financing issues, dividends, taxation
4
Introduction
•
Corporate (business) economics
– Is it worth it to realize a project (investment part)?
– Our final goal is to answer this question
•
Quite hard task
– Estimate the cash flows (far from the accounting p.o.v.)
– Taxation (corporate and personal)
•
•
•
Can we ignore this?
Approximately it takes 50 %, so we’d better not
There are many types of taxes
–
Income taxes, VAT, local taxes, public charges, national insurance
contribution, personal taxes, etc…
– Financing issues, dividend policies
– Without these, analyzing a project is pointless
5
Introduction
•
Business economics
–
–
–
–
Quite young: appeared in the 60’
Before that: macro finances (20-40’)
Economics: 1776 (Adam Smith)
Why did this business part peel off?
•
•
There were companies with revenues, expenses and taxes
Why couldn’t they do this in 1950? What was missing?
–
–
•
What the ‘normal’ profit (%) is of a business activity
• Profit: 10 %  is this really good? More than 5 %.
What is the difference between treasury bonds (2-3 %) and
biotechnology shares (20-30 %)?
• Producing laptops… 10 %  what is the risk of the investment?
• Financing and dividend issues
This was solved in the 60’… at least 10 Nobel prizes (!)
6
Introduction
•
Corporate (business) economics
1. Elementary notions and economic background
•
•
•
Value, utility, swap, alternative cost, efficiency, etc.
Investors’ behavior
Comparative advantages and the market price
2. General aim of a firm
•
•
•
•
Shareholders’ value
Value maximizing, utility maximizing, profit maximizing
Principal-agent problem
Free cash flows
3. Basics of corporate analysis
•
•
•
•
Limited rationality
Estimation of cash flows
Dividends, dividend policies
Independency of cash flows
7
Introduction
•
Corporate (business) economics
4. Cost of capital
•
•
•
•
•
•
Expected utility maximizing
Risk aversion
Efficient portfolios
Relevant risk
Capital market expected returns
Basic models: CAPM, WACC
5. Corporate analysis
•
•
•
Expected profit
NPV
IRR
8
1.1. Economic background of
corporate economics
1.1.1. Value, utility
• These notions are in the background of all economic
decisions.
• What is richness?
– We want to understand what motivates us.
– Money, wealth, good life, happiness?
– Is richness equal to the goods that someone possesses?
• We can’t state that!
• An object on its own is without a value (mouse, laptop).
• …if it means something to someone in a certain
situation…
10
• Only those things increase richness that are
considered useful (i.e. people connect value to
them).
• This value significantly differs among
individuals. But rationally… (money)
• Let’s take some extreme examples!
• Acceleration
• Silence, peace (+1 room, travelling)
• Symmetry
• Taste
• Human performance
• Ability to see far
– What is the real value of Hubble telescope?
•For the astronomers (Big Bang  13,7 Mrd years)… for us?
•1,5 Mrd USD – with a wrong mirror (unclear pictures)
•Correction: 1 Mrd USD
11
• Examples
–How much is it worth for you
• Bricks, cement, gravel, building siting,
• Built in wardrobe,
• Tap,
• Ancient Greek book,
• A box of fined uranium,
• A panel for a computer tomograph,
• A professional baseball glove (for Joe Dimaggio)
– Cycling, bowling… What is the difference?
–We attach value to these things because we think
that there are people who consider these
important, useful.
12
• Conclusions
–Things on their own are useless, i.e. they don’t
have a value. Value occurs only if they mean
something for someone.
–If something has a value it means that it is useful
for someone: it satisfies a sort of desire or need.
–In case of inefficient allocation in the society or
economy
• Things don’t worth their possible ‘maximum value’
• This motivates individuals to swap their possessed goods
among each other
• Goods ‘move’ until they ‘reach’ their maximum value
13
• ‘Value’ – ‘utility’
–They are almost the same notions
–For one person, value  useful and useful  value
• Utility
–An economic term referring to the total
satisfaction received from consuming a good or
service.
–Bernoulli: ‘A thing’s ability to cause happiness to
someone’
–Bentham: ‘An object’s attribute, that makes it
able to cause advantage, satisfaction, good or
happiness for the consumer OR makes it able to
prevent the consumer from any damage, pain, bad
or sadness’ (painkillers)
14
• In an economic sense we connect utility to a
thing in case it is able to satisfy the need of a
member of the society, i.e. someone longs for
it, considers it valuable.
–In a certain situation.
• Conclusion: things have value if they are
(expectedly) useful for someone!
15
1.1.2. Opportunities and choices
• At the roots of the explanations of economic
actions lay the individual choices and behavior
–There are decisions made cooperatively, but we
trace these back to individual behavior, individual
decisions
–We suppose that only individuals have aims
(companies, countries don’t)
• When do we have to make a decision?
–Different actions that have different outcomes
• Two basic mechanism exist
–Rational decision making
–Decisions made in a way to meet society standards
17
• Rationality
–The keystone of economics
–It is still really hard to give a proper, widespread
definition for it (previous slides)
–Difference between psychology and economics:
actions can be considered rational from the point
of view of the psychology that are far beyond the
confines of the economic definition for rational
behavior (afraid of darkness, kindness, sell cheap,
etc.)
–Homo oeconomicus
• Self interest is the only drive
• Not influenced by social standards
• Desires utility
• Clever
18
• The situation is not that bad…
–altruist behavior
• Altruist: to give up something good without any interest
– Traffic, eating, charity
• Is there pure altruist behavior?
• Maybe behind the altruist behavior there is self interest
• China: ‘every citizen has to sacrifice himself for the
Chinese nation’  this is not working, there must be
selfish people as well!
• Parents help their child / someone helps his parents
• Help a sick person
• Anonym contribution
– Someone has to leak this information.
19
• Conclusion
–We consider an action rational in case it
maximizes someone’s expected utility
–Maximizing the ‘happiness’
• Shopping in a shopping mall
– Special combination of goods that causes the maximum utility,
the maximum value
– More precisely: maximizing the expected utility
–We assume a certain level of the altruist behavior
rational.
–If we understand how people decide, we can
calculate with this in the future.
20
• Irrationality
–We can’t always be rational, „the more you want
it…”
–To forget, to behave spontaneously, to frighten
myself, etc.
–To set our desires to our actions and not
conversely: not to do what we desire, but to desire
what we did  we want to be happy so much!
• Cognitive dissonance and posterior self persuasion (that
what we did is very good for us)
–When I can’t reach something
• I explain myself that it is not that good
21
• Irrationality
–Narrowing the possibilities
• Debility of purpose
– Drinking, eating, dentist, gym
• Strategic actions
– Action movies: excluding the possibility of the deactivation of a
bomb
– ‘Burn the boats (bridge) behind the army’
22
– Desire-driven irrational thinking
• To see information as we want to see them (capital market)
• This is not on purpose, there is no control over it
• Collecting information in a selective way until my choice is
verified
• Last information, ‘exclusive’ information from a friend
– Sometimes the best solution is just not the rational thinking
• Incomparable possibilities
– Choosing a university: usually no one has enough information to make
a rational decision, no one can try all of them before deciding
– we decide upon the available set of information (friend, teacher, etc.)
– this is like tossing a coin…
• Let’s take an other example: a firm’s R&D decision
– Estimate the possible (expected) revenues and expenses (already a bit
hazy because we don’t have historical data)
– Behavior of competitors, general market conditions
– To summarize: we don’t have sufficient information to make a rational
decision
– Leadership abilities
23
• When the obscurity of choices and possible
outcomes makes it impossible to make a
rational decision, we have to find an other
solution
–To search for contentment
• Choose something ‘quite good’
–Toss a coin
• It is really rare, people usually don’t like it
• There is no explanation
–Deny the obscurity
• Sometimes it is irrational to insist on rationality
– It is expensive to acquire additional information
– It would be better to accept that the possible outcomes of
different actions can not be evaluated (Excel sheets)
– Pascal: ‘sometimes the most rational thing to do is to give up
rationality’
24
• The rationality of collecting information
–It is not enough to decide rationally upon the
acquired information
–It is essential to be rational during the collection of
information
–Of course, acquiring more information and
exhaustive consideration of the possible outcomes
can improve the success of our decision, but they
have disadvantages as well
• Cost
• Time
– Fast decision versus slow decision
•Investment projects, hospital
•…
25
• Conclusion…
• There are two main parts of rational behavior
1. Rational desires
2. Rational decisions (collecting information and
deciding rationally)
• Keystones in economics
–We consider investors rational
–We do not accept the altruistic behavior
–We accept that
• Efforts to be appreciated and
• efforts to avoid contempt can be considered rational
• This is essential
• The roots of economics  rational utility maximizing
• Economics: explaining human actions, forecast
26
1.1.3. Swap, alternative cost, efficiency
• Formerly: trading was considered as the
‘unproductive sector’
• When (rational) people swap their goods, the values
of these goods differ
• Win-win situation
–Both parties offer something less valuable for
something more valuable
–We can swap our ancient Greek book, the box of fined
uranium, the baseball glove for a house
• Dormitory: room allocation. What happens?
–Both parties enrich, the whole society gains wealth
• Better allocation of goods  enrichment (production)
28
• It is a fact that swaps do not create anything new,
they only reallocate things in the society in a more
valuable way (better allocation)
• Inefficient allocation  efficient allocation
• But this happens in the industry or agriculture as
well (raw materials, human resources, etc.)
• Reallocation in a more efficient way
• Swaps and trading are production activities
– They ‘produce’ wealth, raise welfare,
– contribute to the development of the economy
• Things on their own are without a value (i.e. utility),
they have to be in the ‘right hands’
– Trading activity is substantial for this
• With or without a dealer (GDP, soldiers' uniforms)
29
• During swaps one sacrifices the value of the
things he gives up (book, uranium, glove, etc.)
–Sacrifice that one makes  cost
–The cost is not connected to the things that one
gets, but to the things he gives up
• Cost of sitting here (school fee), working, money
–i.e.: costs are alternative costs because they are
connected to the alternative possibility that has
been given up
• This is in strong connection with our utility or
value maximizing approach
–The gained utility exceeds the lost utility
–The lost utility is the alternative cost
30
• Efficiency: output / input ratio
–It is not an objective notion (previous slides)
• Both are quite indefinite
– Is it efficient to travel by car, to go to the theatre, wear a suit, to
build a telescope
–Depends on the person and the situation
• Heating a house with gas or with wood or with solar
energy
• Which one should be considered efficient?
• It changes in time
– Depends on how rare the gas or wood is
– What kind of alternative utilization exists for them…
• Debates - Who has the right to decide?
–Heating at home, debates with the neighbour
• Subjective economics (Marx - value)
31
1.1. Economic background
1.1.1. Value, utility
1.1.2. Possibilities and choices
1.1.3. Swap, alternative cost, efficiency
1.1.4. Comparative advantages and the price
33
1.1.4. Comparative advantages and the price
• Two wine growers – a ‘good’ and a ‘bad’ (?)
Villány
1000
1000
900
900
800
800
szamorodni
szamorodni
Tokaj
700
600
500
400
700
600
500
400
300
300
200
200
100
100
100 200 300 400 500 600 700 800 900 1000
100 200 300 400 500 600 700 800 900 1000
kékfrankos
kékfrankos
34
tokaji
1000
1000
900
900
800
szamorodni
szamorodni
800
700
600
500
400
300
600
500
400
• Tokaj: for 1 l szamorodni 
0,5 l kékfrankos
• Villány: for 1 l szamorodni 
kékfrankos
1,25 l kékfrankos
200
200
100
100
kékfrankos
villányi
1000
900
800
szamorodni
700
300
100 200 300 400 500 600 700 800 900 1000
700
600
500
400
300
200
100
1000
villányi
–The ‘szamorodni’
is relatively
cheaper at the ‘Tokaj’ producer,
he is more efficient in its growth:
he has comparative advantage in
producing ‘szamorodni’
100 200 300 400 500 600 700 800 900 1000
kékfrankos
100 200 300 400 500 600 700 800 900 1000
–Conversely: the ‘Villány’
producer is better in
‘kékfrankos’, he has a
comparative advantage in this
• Tokaj: for 1 l kékfrankos 
2 l szamorodni
• Villány: for 1 l kékfrankos  0,8 l
szamorodni
35
• Suppose that they specialize in the wine in which
they have comparative advantage, and swap them!
Tokaj
Villány
900
900
800
800
700
700
szamorodni
1000
szamorodni
1000
600
500
400
600
500
400
300
300
200
200
100
100
100 200 300 400 500 600 700 800 900 1000
100 200 300 400 500 600 700 800 900 1000
kékfrankos
kékfrankos
• It is a win-win situation!
36
• Suppose that the demand is 50-50 % of the
two wines in both regions!
• Specialization and swap is worth it even if it
has costs (‘export-import’  trading, spec.).
Tokaj
Villány
900
900
800
800
szamorodni
1000
szamorodni
1000
700
600
500
400
700
600
500
400
300
300
200
200
100
100
100 200 300 400 500 600 700 800 900 1000
100 200 300 400 500 600 700 800 900 1000
kékfrankos
kékfrankos
37
• Let’s look at this from a different aspect!
– What changes if the possibility of the production a third
type of wine arises and
– the production of this wine is more advantageous than the
previous ones?
• Simply our example wouldn’t be correct…
– We are interested in the second best opportunity
• There is no point in dealing with the ‘szamorodni or
kékfrankos’ problem, in case there is something even
better
– The sacrifice is always the ‘second best’
– Economic decision making is always about choosing
between the 1st and the 2nd best possibility! (we don’t deal
with the potato)
38
• Suppose that the price of the ‘szamorodni’ is quite
high, and the best solution is that the two actors
produce only ‘szamorodni’
– In this case there must be a third party, who is ‘good’ at the
production of the other wine. It is impossible that
something is cheap while everyone produces it at higher
expenses, ie. alternative costs (sacrifices).
– if there is such an actor, we could think that the one who
produced 600 liters of ‘szamorodni’ would go bankrupt,
since he does this at higher costs
• This is impossible!
– The costs in Tokaj (loss-making): land, unskilled labor,
equipments, entrepreneur…
• One of the costs above is not defined correctly!
• Most likely the entrepreneur deserves a lower profit for his activity
(he will be poor).
39
• The cost or price of the things (land, equipment, people)
tend to their best possible way of utilization!
–If the best way of utilization of the land is to produce
wine there, then the land’s value tend to the value that
people connect to wine
–Goldmine?
• Everyone is competitive in his best domain of utilization,
the worst that can happen is that this specific area is not
outstandingly valuable for anyone
• The optimal solution for everyone is to use his property
and workforce according to their comparative
advantages
–and swaps/changes afterwards
40
• This leads to specialization and swaps
–There are less and less handyman
• To build a house, heal our children
–What will you be when you grow up?
• Find your comparative advantage
• And ‘pray’ for this being valuable for someone
• People’s need for swaps (due to the
specialization) led to the appearance of an
ultimate ‘means of exchange’: the money
–Money has an abstract utility
–It not directly gives happiness, but creates the
possibility of acquiring happiness
–The utility of money is equal to the utility of
goods that you can buy with it
41
• Limits of swaps
• There are costs connected to the matching of
the actors of an exchange
–Transport
–Searching for the possibilities (who is the best?)
• We call these transaction costs
• Traders
–Their comparative advantage is in finding both
sides of an exchange, to settle up a trade
–They are essential for specialization
–They produce the necessary information
(transportation, where to buy, etc.) for exchanges at
lower costs than others
42
• Traders compete with each other
–and with everyone else
–you just don’t have the time to deal with this and
you are willing to pay for this service
–(interior designer, hairdresser, etc.)
• Traders are evil because they use the ignorance
of others (buy cheap, sell expensive)
–Correct
–Like everyone else (architects, doctors, car
mechanics)
43
• Costs: conclusion…
• Costs are not objective, they are not
connected to the acquired objects
–They occur for someone in a certain situation
–To acquire something, the one has to give up the
utility of something else  alternative cost (lost
utility)
• I.e. costs are connected to the (human)
evaluation of the alternative utilization
possibilities
44
• Costs are equal to the utility that has to be
given up, in a MARGINAL sense (MC)
• The point: what else do I have to sacrifice?
–Marginal alternative costs
• Examples
–Correction of the Hubble Telescope
–Airplane development
• It is really important that we do not care
about sunk costs!
• Cost that occurred in the past
• Decision has been made in the past
45
• There are alternative possibilities in the
production as well
–The best technology does not exist
• Building highways is New-Delhi
• A job ‘offer’: we give up something for money
• From a ‘marginal’ point of view
46
1.2. Shareholders’ value
maximizing
1.2.1. Profit
• ‘Maybe the profit is the most improperly used
notion in economics’ – Frank Knight
• Our income minus all the costs that occur
• Two remarks
–Wages, rents  we do not consider these as a
‘profit’
–Usage of capital  interest
48
1.2.1.1. Interest, return
• These are not profits either
F1  F 0 F1
r

1
F0
F0
In a year’s time
F n  F 0 (1  r )
n
Now
1  rnominal  (1  rreal )(1  rinflation)
 1  rreal  rinflation  rreal  rinflation
 1  rreal  rinflation
rreal  rnominal  rinflation
49
1.2.1.2. Risk free interest
• The interest rate of risk free borrowing
–Compensation, remuneration for…
• Positive time preference
• Technical, technological, economic development
–T-bonds
50
1.2.1.3. Risky return
• Risky investment’s expected return
–Compensation, remuneration for
–Positive time preference
–Risk aversion (return above the RF interest … of
course this is just an expected ‘premium’)
–Possibility of utility-loss
E ( F1 )  F 0 E ( F1 )
E (r ) 

1
F0
F0
51
• Risk
–Deviation from the expected value
–Fluctuation/oscillation
–Standard deviation
• Normal distribution
–The effect of many factors
–Purely random
–Expected value - distribution
• Expected return
E ( F1 )  F 0 E ( F1 )
E (r ) 

1
F0
F0
52
Risk free loan
Risky investment
E(F1)
F1
F0
F0
E(r)
E(r)
E(r)
rf
53
1.2.1.4 Expected and realized profit
• Income minus our costs
– Wages, rents, interest
– Other apparent costs (vendors, taxes, etc.)
• The ‘rest’ (positive or negative) is for the
owner of the company  is this profit?
• We can talk about profit if we subtract the
costs of the owner (alternative costs)
– Wages, interest of his capital, rents of his assets
contributed to the company, etc.
– And the ‘rest’… that is the profit!
– What is the cost of you giving me…?
54
• Is it possible that in a competitive market
economy a firm can make profit (excess
return) without any ‘special effort’?
–Of course not! The competitors will appear.
• To make profit, some kind of special
‘knowledge’ is essential
–Just like everywhere else
–Arbitrage, innovation, copying others
• Creativity, intuition, charisma, steadiness
• Entrepreneurs have comparative advantages
in these. His profit is his remuneration for the
abilities above.
• This knowledge can be bought or sold
55
• This knowledge  manager
• Taking risk
• Profit
–Expected
–Realized
–Expected – realized
–Knowledge – fortune
• The owner
–takes the risk
–gets the profit
–demands the profit maximizing corporate
behavior (expected profit)
• Primary goal of a firm
56
1.2.2. Shareholder’s value
• Company (products - services)
– Public company
– Shareholders  corporate objectives
– Shareholders’ objective
• Utility maximizing
• Value maximizing
• Profit maximizing
57
1.2.3. Principal / agent
• Early capitalistic firms
– Owner and the manager: the same person
• Legally responsible for the company’s actions with his whole
property
– Mass production  concentration of capital
• To do something together
• Problem of joint responsibility
• Public companies
– Limited liability
– Clear proprietorship
– Legal entity
• Owners and managers are separated
• Buying and selling became really easy (capital market)
• Huge advantage in capital concentration
58
–Many owners – one company
–Management  agents
• Everybody can’t participate
–Principal (owner)-agent problem
• Supervision  costs
– Specialists
– BOD
– auditors
• There is a rational limit
– Capital market information
59
1.2.4. Free cash flows
• Corporate analysis is expressly connected to the
aim of the shareholders
–Stakeholders (other ‘owners’) are not important
• The question is: what is the ‘rest’ for the owners
–After customer payments, wages, vendors, other
costs, taxation, lending operations
• The ‘rest’  Free Cash Flows (FCF)
–this is still not the profit
–Because there is the (alternative) cost of the capital
• Simplify the problem of the contributed assets
61
0
E(F1)
1
E(Fn)
E(F2)
2
…
n
…
E(FN)
N
F0
•Free cash flows in a company
•We still have to calculate with the cost of the capital
•Cost of not doing something else with the money
•Discounted cash flows – what is the value of E(F1)?
62
1.3. Basics of corporate analysis I.
1.3.1. Limited rationality
• We already know what perfect rationality is
–‘Good’ or ‘bad’ – ‘Which one is better’?
• A problem contains enormous amount of
‘built-in’ analysis
• Limited rationality
–Economies of scale  this is rational!
63
1.3.2. Estimating the cash flows compromises
• Annual CF
–Accounting, taxation
–Annual ‘rhythm’
• Specialists – Department of Finance
64
Specialists
Ár
Db
Költségek
Db
Ár
Költségek
DbÁr
Költségek
Dpt. of Finance
0
E(F1)
1
E(Fn)
E(F2)
2
…
n
…
E(FN)
N
F0
65
1.3.2.1 Separation of the expected cash
flows and the risk
E(F1)
66
1.3.2.2. Real cash flows
• Inflation?
• We have to conciliate this with the cost of
capital
–Cost of capital  in real sense
–Constant prices
• Typical problems
–Depreciation
• Real and nominal sense
67
1.3.2.3. Revenue and costs
• Not posterior analysis, but future estimations!
• Revenue and costs that occur due to our
decision
–With or without it?
• Inevitable revenues and costs  irrelevant
–Happened in the past
–Has been decided in the past
–These are sunk costs!
68
• Costs
–Resources that we have to acquire
• The market price
–Resources that we already possess
• Irreplaceable
– Best alternative utilization
•Selling it
•Possible realized value in an other project
• Replaceable
– Maximum its market price
– Minimum its selling price
• Zero: if it can’t be sold or used somewhere else!
69
C
FC
Q
70
C
VC
•Economies of scale
Q
71
• FC + VC = Total Costs (TC)
• Our fix costs are sunk costs  these are
irrelevant!
72
1.3.3. Indifference of dividends
• Let’s get back to FCFs! Are these equal to the
dividends (of course after taxation)?
• To answer this, first we have to clarify the
notion of ‘indifference of dividends’
–Wealth of the shareholders does not depend on the
‘rhythm’ of dividends
–For this,
• The perfect representation of the shareholders’ objectives,
• Zero transaction costs,
• Efficient capital markets,
• Taxation system without distortions are needed
73
1.3.4. Independency of cash flows
• Indifference of dividends
–Its consequences on our approach
• The goal is not the maximization of the corporate value,
but the shareholders’ value
–Its consequences on the analysis
• Are free cash flows equal to the dividends (after taxation)?
• Not necessarily, but regarding their ‘value’, they are!
• If this holds, the most practical thing to do is to suppose
that these free cash flows are always paid immediately to
the shareholders as dividends
• Usually this does not happen so, but from the point of
view of the shareholders this is indifferent
• We suppose continuous cash inflow and outflow (CICO)!
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• This has an outstanding importance in
corporate analysis
–Cash flows of different projects are separated this
way
• Separate CICO diagrams
–A project’s cash flow can be (and should be) treated
separately
–This is the independency of cash flows!
• Free cash flows – dividends after taxation – net
cash flows
• We have to subtract the cost of the capital
–The cost of the capital that he did not take
somewhere else (our alternative cost approach)
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1.4. The cost of the capital
• Capital market  ‘market of capital’
–Capital for different durations, with different risk
–swapping money (‘present money’ – ‘future
money’)
–field of this swap
• We will examine the investors’
–Preferences,
–Risk perception,
–Pricing of different investment possibilities
• Our basic model: Capital Asset Pricing Model
(CAPM)
–Most widespread financial model
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1.4.1. Maximizing the expected utility
A: 10 000 $ with a probability of 60 % or 0$ with 40 %
• How do people decice?
B: 6– 000
withsituation
a probability of 50 % or 4 000 $ with 50 %
In a $risky
• We make decisions according to the ‘value’?
–Is this pure mathematics?
E W
 
i
pi wi  max
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• Not the acquired amounts are important, but
their consequences, their ‘utility’. Thus people
don’t maximize the expected value, but the
expected utility:
E U W     p i U ( w i )  m a x
i
• W* wealth at the start point, F cash flow causes
ΔW (change). With the approach above, it is the
same if we talk about the utility maximization of
F cash flow, or W wealth:
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1.4.2. Risk aversion
• What is the basic difference between the
maximization of the expected value and the
maximization of the expected utility?
• Value – utility, utility – value
• Apparently the increase of the amount of
money is not proportional to the increase of its
utility
–In such case it would be the same to talk about the
maximization of the expected value or the
maximization of the expected utility
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1.4.2.1. Decreasing marginal utility of money
MU(W)
MU(F)
U(W)
U(F)
More money
is better...
W, F
‘The increase of the utility of wealth is in inverse
proportion to the amount of goods already
possessed’ (…) ‘This hypothesis seems to be valid
for many people’ (Bernoulli)
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1.4.2.2. Expected utility – standard
deviation preference map
• We still searching for the answer to the
question: ‘how do people decide in a risky
situation’?
• We summarize everything in one model
–Maximization of the expected utility
–Decreasing marginal utility of money
–Normal distribution
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σ(rB)
σ(rC)
E(U)
σ(rD)
E(U*)
F AE(F B) E(F C) E(F D)
F
• Suppose that we can get FA, E(FB), E(FC) and
E(FD) for F0 investment. We arrive to
returns…
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E(r)
rA
E(rB)
E(rC)
E(rD)
E(U*)
σ(rB)
σ(rC)
σ(rD)
σ(r)
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