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# Risk analysis Chapter

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This is a presentation of Chapter 13 Risk Analysis based on the textbook Managerial Economics written by W.Bruce Allen, Keith Weigelt, Neil A. Doherty and Edwin Mansfield 8th Edition

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### Risk analysis Chapter

1. 1. LOGO Chapter 13 Risk Analysis Your Site Here Presented By: Singhzee and Group Economics
2. 2. To study a variety of tools to help managers improve decision making To understand the concept of expected value To examine techniques to reduce uncertainty To understand the concept of expected utility Objectives
3. 3.  Risk and Probability  Probability Distributions and Expected Value  Comparisons of Expected Profit  Road Map to Decision  The Expected Value of Perfect Information  Measuring Attitudes towards risk  The Standard Deviation and Coefficient of Variation Measures of Risk  Certainty Equivalence Contents
4. 4.  Hazard or a chance of loss  Bigger the chance of loss/Greater the size of loss = the more risky the action Risk and Probability
5. 5. Frequency Definition of Probability  Proportion of times an outcome occurs  Over the long run  If the situation exists repeatedly  E.g. A dice is thrown  Probability of 1 = 1/6 or 0.167 Risk and Probability Ctd…
6. 6. Subjective Definition of Probability  Managers ‘ Degree of confidence or belief  That event will occur  Used when experiments cannot be repeated  Use of Managers’ judgment  High probability for higher degree of confidence and vice versa Risk and Probability Ctd…
7. 7. Subjective Definition of Probability Risk and Probability Ctd…
8. 8. Subjective Definition of Probability  For example:  Introduction of a new product Risk and Probability Ctd… High Demand is more likely Low Demand is less likely Both equally likely
9. 9. Probability Distributions  A Table listing  All possible outcomes  Probability of their occurrence
10. 10. Expected Value  Weighted Average  Of the profit of each outcome to its profit  Weights = Probability of their occurrence Events Probability Profit P* New Robot developed in 1 yr 0.6 \$1,000,000 \$600,000 New Robot not developed in 1 yr 0.4 -\$600,000 -\$240,000 \$360,000
11. 11. Comparison of Expected Profit  To decide the course of action  For example: Jones Corporation Decision Alt Events Profit P P* ExpProfit Increase price Ad Campaign Successful \$800,000 0.5 \$400,000 \$100,000Ad Campaign Unsuccess ful -\$600,000 0.5 -\$300,000 Do not increase price \$200,000
12. 12. Road Map to Decision  Decision Tree  Visualization strategic future  Series of choices  Decision Fork o Choice/Decision Alternative o Square/Decision Node  Chance Fork o Events influencing outcome o Dotted or Circular Node
13. 13. EVPI Expected Value of Perfect Information(EVPI) How much would you pay to gain access to perfect information? Completely Accurate Information About Future Outcomes Increase in Expected Profit To Reduce Uncertainty
14. 14. EVPI Continued… EVPI=Expected Profit with Perfect Information- Expected Profit without Perfect Information Example:  Research Survey Report Survey says Prob Decision Profit Prob*Profit Campaign Successful 0.5 Increase \$800,000 \$400,000 Campaign Unsuccessful 0.5 Do not Increase \$200,000 \$100,000 Total Expected Profit with Perfect Information \$500,000 Total Expected Profit without Perfect Information \$200,000
15. 15. EVPI Continued… EVPI=Expected Profit with Perfect Information -Expected Profit without Perfect Information = \$500,000 - \$200,000 = \$300,000 Access to Perfect Information Profit Increase by \$300,000
16. 16. Measuring Attitudes toward risk: The Utility Approach Certain Profit \$2,000,000 Gamble(50/50) \$4,100,000 -\$60,000 Expected profit =0.5(\$4100000)+0.5(-\$60000) = \$2020000 Small Business Managers Large Business Managers
17. 17. Constructing a Utility Function  Utility Function=Level of satisfaction  Expected Utility Sum of utility of each outcome times probability of the outcome’s occurrence
18. 18. Constructing a Utility Function Example: Tomco Oil Corporation
19. 19. Constructing a Utility Function Payoffs Utility(U) \$500,000 50 \$300,000 10 \$100,000 20 \$0 10 -\$90,000 0  Example: Tomco Oil Corporation
20. 20. Attitudes towards Risk  Three Types Risk Averter Risk Lover Risk-Neutral
21. 21. Risk Averter Choice: Certain outcome
22. 22. Risk Lover Choice: Uncertain outcome
23. 23. Risk-Neutral Maximization of expected wealth Regardless of risk
24. 24. Measures of Risk 2. •Example: •Jones Corporation •Investment Decision for a new plant 1. • Dispersion of Probability Distribution • Profit from the Decision
25. 25.  Magnitude of negative outcomes  Dispersion of Probability distribution Measures of Risk  For Example:  Jones Corporation  Decision to invest in a new plant Panel A Panel B
26. 26. (1)Standard Deviation  Most frequently used metric for dispersion  Square root of the deviation of expected values from payoffs  Absolute measure of risk  For Example:  E(∏)=0.3(1)+0.2(0.4)+0.3(-0.6) = \$0.2 \$1 m • 0.3 \$0.2m • 0.4 -\$0.6 • 0.3
27. 27. (1)Standard Deviation Payoffs(\$) Probability 1 0.3 0.16 0.192 0.2 0.4 0 0 -0.6 0.3 0.16 0.192 0.384 Higher Standard Deviation Higher Risk
28. 28. (2)Coefficient of Variation(V)  Relative measure of risk  Ratio of S.D(σ) to Expected Profit [E(∏)]  Lower the V better the risk-return trade off
29. 29. Adjusting the Valuation Model for Risk  Effects of managerial decision  PV of future profits  Certainty Equivalent Approach
30. 30. Certainty Equivalent  A guaranteed return  someone would accept,  Instead of taking a chance on a higher, but uncertain, return.  Example: Job Vs Own Business  Salary=Certainty equivalent Certainty Equivalent Approach
31. 31. Click to Edit Title Sub Title Sub Title
32. 32.  Adjustment of Discount Rate  Construction of Indifference Curve  Estimation of Risk Premium  r=sum of riskless rate of return+risk premium Use of adjusted Discount rate
33. 33. A B C D 1 2 3 4 Click to Edit Title r=8+4=12%
34. 34. LOGO Thank You!