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INTRODUCTION:
Decision-making problem:
There are certain essential elements which are common to all such problems. These
are:
DECISION-MAKING PROCESS:
Step 1: Determine the various alternative courses of action from which the final
decision is to be made.
Step 2: Identify the possible outcomes called the state-of-nature for the decision
problems. The events are beyond the control of the decision-maker.
Step 3: Determine the payoff function which describes the consequences resulting
from the different combinations of the act and events.
Step 4: Construct the regret opportunity loss table. An opportunity loss occurs due
to failure of not adopting best available course of action.The opportunity loss values
are calculated separately ofr each outcomes (state-of –nature) by first locating the
most favorable course of action for that outcomes and then determining the
departure of the payoff value for that course of action and payoff value for the best
possible course of action that could have been selected.
Consider a fixed state-of –nature Ei (i=1, 2 ,3………..n) for which the payoff
corresponding to the n courses of action are given by Pi1, Pi2,…….Pm. Let M1 be
the payoff for the least possible occur of action. The opportunity loss table will be
shown as follows:
DECISION-MAKING ENVIRONMENT:
Under uncertainty, only payoffs are known and nothing is known about the
likelihood of each state of nature.
The Laplace uses all the information by assessing value equal probabilities to the
possible payoffs for each action and then selecting that alternatives which
corresponds to the maximum expected payoff.
Step 3: Select that alternatives which corresponds to the maximum of the above
expected payoffs.
The maximin is based upon the “ conservative approach” to assume that the worst
possible is going to happen. The decision maker consider each strategy and locates
the minimum payoff for each; and then select that alternatives which maximizes the
minimum payoff.
When dealing with the costs , the maximum cost associated with each alternative
criterion used is the Minimax and carried out in two steps:
The maximax is based upon “extreme optimism “.The decision maker selects that
particular strategy which corresponds to the maximum of the maximum payoffs for
each strategy.
Step 2: Select that alternative which corresponds to the maximum of the above
maximum payoffs.
:Hurwiez Criterion stipulates that a decision maker`s view may fall somewhere
between the extreme pessimism o maximum criterion and the extreme optimism of
the maximum criterion. The criterion provides a mechanism by which a balance
between extreme pessimism and extreme optimism is made b y weighing them
with certain degrees of optimism and pessimism.
Step2 : Determine the maximum as well as minimum payoff for each alternative
and obtain the quantities.
When a decision maker chooses from among several options whose probabilities of
occurrence can stated, he is said to take decision under risk. The probability of
various outcomes may be determined objectively from past data. However, past
records may not be available to arrive at the objective probabilities. In many cases
the decision-maker may, on the basis of his experience and judgment, be able to
assign subjective probabilities to the various outcomes. The problem can then be
solved as decision problem under risk.
Under condition o risk, the most popular decision criterion for evaluating the
alternatives is the expected monetary value or expected opportunity loss of the
expected payoff.
Expected Monetary Value (EMV) Criterion:
The EMV for a given course of action is the expected value of conditional payoff for
that action. The conditional payoffs are obtained for each action by considering
various act-event combinations. The EMV criterion may be summarized as :
Step1: List conditional profit for each act-event combinations, along with the
corresponding event probabilities.
INTRODUCTION
Every individual or firm wishes to know how 'best' to invest money to attain the
maximum gain. To achieve this objective, a proper investment analysis is to be
made. It
involves the consideration of investment proposals, estimation of their cash flows,
evaluation of cash flows, selection of the proposals based on some criterion and
finally the continuous revaluation of these proposals (projects).
Thereafter, interrelations between cost, revenue, volume, and the profit planning
(i.e., break-even analysis) have been discussed.
One of the basic concepts of finance is the notion that money has time value. This is
because money today is more valuable than the same amount at 'some future date.
We can
alw ays put available funds to some use and" make them grow into higher sums, so
that a
larger sum would be available later on. A rational decision-maker would not value
the
opportunity to receive some amount of money now, equally, with the opportunity to
have
the same amount of money at some future date. This phenomenon is known as the
decision
maker's 'time preference of money'.
The time preference for money is generally expressed by means of an interest rate.
For
exam pie, if the time preference rate of an individual is 10%, he may forego the
opportunity
of receiving Rs. 100 now if he' is offered Rs. 110 after one year. There, amounts to
pay him
the current principal (Rs. 100) plus the interest that would accrue on it after one
year
@ 10% p.a. Like individuals, firms also have time preference (or discount rate).
They use
this rate in evaluating the alternative decisions.
Compound Value
Consider the situation, when the investments involve more than one year.
Let the
interest, as it becomes due, is added to the principal, and the amount, thus,
obtained forms
the principal for the next time period. Then, the mode of interest
computation is called
Compound Interest. The time period after which the interest is added each
time to the
principal to form the new principal is called Conversion Period and amount
received after
the last conversion period is called the Compound Value. The difference of
the compound
value and the original sum borrowed is the amount of Compound Interest for
given
can version periods.
Present Value
The present value (PV) is the amount of money that represents the sum of
principal
and interest if P (i.e., principal) is required to be invested now at a certain
rate
compounded over a number of time periods at a specific rate for each time
period.
The present value of the amount A (n) due at the end of n interest periods at
the rate
of r (in percentage per conversion period) may be obtained by solving for P,
the following
A (n) = P (1 + r)^n or P = A (n) x, (I + r)^-n
Continuous Compounding
A (n) = P ( 1 + r / f)^ n f
Instead of investing a lump sum amount initially, once may invest a constant
amount
annually (or monthly) or at equal intervals for a designated period of time.
The investment
is generally assumed to be made at the end of each period. The constant
periodic sums are
called annuities. A recurring deposit amount in Post Office/Bank, payment of
insurance
premium, etc., are the examples of annuity. It may be noted that-
(a) The size of each payment of an annuity is called the periodic payment.
(b)An annuity which is payable forever, i.e., which never terminates is called
perpetuity.
(c)The total time from the beginning of the first payment period to the end of
last
payment period is known as the term of annuity.
(d) The algebraic sum of payments and the accumulated interest is known as
the amount of annuity.
(e) The present value of an annuity is the sum of the present values of its
installments.
Amount of an Annuity
The first payment, being made at the end of the first time period, shall carry
accumulated interest for (n - I) time periods, the second one would similarly
carry
interest for (n - 2) time periods, and so on. The last payment would not carry
any interest,
because it is made at the end of the term. Thus, the amount of an ordinary
annuity of Rs. p
per period for n periods at the rate of r per period is given by
A(n, 1') = p(1 + r)^n-I-+ p(1 + r)^n-2 + ... + p(l + 1') + P
Multiplying this equation on both sides by (I + r), we get
(I + r)A(n. 1') = p(1 + r)n + p(l + r)n-I + ... + pel + 1')2 + p(1 + 1')
On subtraction, these equations yields
[(1+r)-1]A (n,r)=p(1+r)^n-p
A (n, r) = p[(1+r)^n-1] / r
Types of Annuities
In general, there are two types of annuities, namely annuity certain and
annuity
contingent.
(a) Annuity Immediate. If the payments fall due at the end of each period,
the
annuity is called an immediate or ordinary annuity.
(b) Annuity Due. If the payments fall due at the beginning of each period, the
annuity is called annuity due. In this annuity, the first payment falls due at
the
beginning of first interval, the second payment falls due at the beginning of
the·
second interval, and so on. Premium on life insurance policies illustrate the
point.
(c) Deferred or Reversionary Annuity. If the money is allowed to accumulate
for a
certain period and the payments begin after the lapse of that period, the
annuity is
called deferred or reversionary annuity. For example, when the house
building
loan is granted to a person, the repayment of loan begins after the expiry of,
may
be, a year or two from the date of grant of loan.
It may he noted that the interest is compounded at the end of each payment
period.
Let us, now, consider an annuity of 1 1 payments of y (rupees) each, where
the interest
rate per period is r and the first payment is due one period from now. Then,
the present
value of the annuity is given by
Hence, pv = x*
PVP= (A / r)
Where PVP = present value of perpetuity.
A = constant annual cash flow.
r = rate of interest.
Thus,
PV = x (I + r)^-i+1 + x (l + r)^-1+2 + ... + x (I + r)^-i+n
PV=x/r(1+r)^-1 [1-(1+r)^-n]
Sinking Fund
If A is the amount to be saved, and P, the periodic payment: then size of the
sinking
fund is computed by using the following formula
A = R [(1+i)n-1]/i R = Ai/(1+i)n -1
R = Ai/(1+i)n -1
R : periodic payment.
n: number of periods.
i: interest rate.
b ) The returns (or net cash-inflows calculated on yearly basis) over the
economic life
of the asset.
(c) The economic life of the asset. Economic life is usually shorter than
durable life
due to technological advancements.
I. Traditional Methods these include (a) Payback Period method, and (b)
Average
Rate of Return method.
2. Discounted Cash Flow (DCF) Methods These include (e) Net Present
Value
(NPV) method, (d) Internal Rate of Return (IRR) method, and (e) Discounted
Payback Period method.
(p) = Cash outlay (P)/ average met cash inflow per year(R)
60,000/12000 = 5 years
It may be noted that the proposal will be accepted, only if payback period is
5 years or less.
(c) Net Present Value (NPV) Method This method takes into account the
time value
of money. It correctly postulates that cash flows arising at different time
periods differ in
value and are comparable only when their equivalent ‘present values’ is
found out.
Remark I. The NPV method can be used to select between mutually exclusive
proposals by considering
whether the incremental investment generates a positive NPI'. Using this
method, the proposal would be ranked in order of theirNPV values.
(d) Internal Rate o r Return (IRR) Method. The internal rate of return is
the rate at
which. an investment. is repaid by proceeds from a project. In other words, it
is the rate that
c:quates the present value of the 'cash inflows with the present value of cash
outflows of an
investment. It is determined by using the following formula:
where CF represents that Cash Flow generated in particular time
period
N represents the last time period.
R represents IRR value.
Note: The value of r in the above equation is determined by trial and error.
We select any rate of interest to compute PI' or cash inflows. If the calculated
PV of cash inflows is lower than the PV of cash outflows a lower rate interest
is to be tried. On the other hand. a higher rate should be tried. if the PI' of
cash inflows is higher than, the PI' or cash outflows, The process is to be
repeated till the NI'V becomes zero.
Remark I: may be observed that the IRR formula is same as used for the NPV
method with the difference
that in the NPV method, the required rate of return 'is assumed to be known
and then the NPV is calculated whereas in the IRR method the value of r
has to be determined such that the NPV is zero.
The number of years required to recover the initial amount is 3 years. Hence
the
discounted pay-back period is 3 years.
Medium demand
(18 lakhs*0.3=5.4lakh)
Build large plant
10 lakhs
Large demand
(22lakhs*0.3=6.6lakhs)
Build small
plant 4lakhs
Decision
node2
Large demand
(0.5*19=9.5lakhs)
Colum
n1 Column2 Column3 Column4 Column5
sr. no. Decision Returns Earned Total Returns Decision
return earned -
investment
From both th options we can observe that the action 1 is more profitable. So
the company should go ahead with building large plant as it involves less
cost and more profit.