Uncertainty and Capital Budgeting
ACCT 7320, 12/8/09, Bailey

This presentation contains two parts:
– A general model of decision-making under
uncertainty, using “expected value”
– Discussion of “Using Decision Trees to
Manage Capital Budgeting Risk,” J. Bailes & J.
Nielsen, Management Accounting Quarterly, Winter 2001
3-1
Decision Models and Uncertainty
Managers frequently must deal with
uncertainty.
 The model presented here represents a rational
approach to decision making under
uncertainty, assuming you are risk-neutral.

3-2
Decision Model Assumptions
Choice Criterion
 Set of Alternatives (Actions to consider)

Mutually exclusive, Exhaustive
Set of Events (States of Nature)
 Set of Probabilities associated with the events
 Set of Outcomes (Income, cost, etc., to
minimize or maximize)

3-3
Example of DM under Uncertainty
E
v
e
n
t

Get Govt
Contract
Not get Govt
Contract
Action Taken
Buy new Eqpt Keep old Eqpt
Income =
Income =
$500,000
$300,000
Income =
$10,000
Income =
$200,000
Which action is best?
Depends on probabilities we assign to the events.
3-4
Decision Models and Uncertainty

EV=Σ (Outcomei) (Pi)
i.e., summation of each outcome (in this case, income)
times the probability of that outcome.

Suppose P(getting contract) = .20
[read as “probability of getting contract = .20”]

Thus P(not getting contract) = .80.
EV(buying new Eqpt) = $500,000*.20 + $10,000*.80 = $108,000
EV(keeping old Eqpt) = $300,000*.20 + $200,000*.80 = $220,000

To maximize expected value, we keep old equipment.

3-5
Forest Product Companies and
Timberland
Long-term capital-budgeting decisions
– More risk
– Time value of money especially important
 Typical decision:
– Buy timberland now, or
– Buy timber as needed

3-6
The basic decision
Starting point in hypothetical case assumes indifference
given the current regulatory environment, for simplicity only.
3-7
Uncertainty: Regulatory
environment may change
Management’s estimates.
3-8
Possible Regulatory Environments
and Related Outcomes
$6.57.0
$6-4.5
3-9
Expected Values of the Two Actions
3 - 10
The End
3 - 11