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Dealing with Risk and Uncertainty (Ways of Valuing Projects and Analysing…
Dealing with Risk and Uncertainty
Ways of Valuing Projects and Analysing Risk
Expected value
Variance/Standard Deviation
Information
Value of information = Expected value with information - Expected value without information
Decision Trees
Risk Seekers vs Risk Averters
Risk Seekers
Choose project with highest return given the best possible outcome/event (maximax)
Risk Averters
Choose project with highest return given the worst possbile outcome/event (maximin)
Regret Criterion
Choose project with lowest regret (differences between the project's outcome and the best outcome for each possible state
Diversification
Firms can reduce risk by spreading their risk across multiple projects
Advantages and Disadvantages of Probabilistic Decision Analysis
Advantages
Forces management to recognise risks and quantify their impacts
Improves decision-making
Disadvantages
Tend to look at decisions in isolation
Predicted outcomes and probabilities are a simplification - decisions are generally only taken once whereas expected value considers the long-run value