Page 200 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 4 = 30000 × 0.909 + 20000 × 0.826 – 40000 = 43790 – 40000 = + 3790
5 = 30000 × 0.909 + 25000 × 0.826 – 40000 = 47920 – 40000 = 7920

6 = 30000 × 0.909 + 30000 × 0.826 – 40000 = 52050 – 40000 = 12050
The last column shows the expected NPV, which is obtained by summing up the product of NPV
and corresponding joint probability. The term of these weighted NPV is positive and therefore,
the project would be accepted.
This DT approach has the advantage of exhibiting in a bird’s eye view of all the possibilities
associated with the proposed project. Management also becomes aware well in advance of the
adverse possibilities when NPV is negative. The conditional nature of cash inflow associated
with the project is clearly shown. The main limitation of the method is that decision format may
become itself complex and difficult to understand and construct if the number of years of the
expected life of the project and the number of possible outcomes for each year are of large. For
instance, if we have 3-year project, there will be 27 paths (i.e. 33) and 59,049 (31") paths if the
project life is 10 years, assuming only three possible outcomes.

9.7.6 Applied Utility Theory
If the risk factor of the top management (i.e. the group that makes decisions regarding investment)
can be translated into a utility curve, the risk factor can be incorporated in the final decision in
a fairly simple and consistent manner.

Did u know? A utility function describes a person’s risk attitude.
The utility function shows the utilities (an arbitrary measure of satisfaction) associated with
different monetary outcomes. Normally, utilities are shown as the vertical axis and monetary
returns are shown on the horizontal axis. A person’s utility function can be obtained as follows:
1. Find the monetary incomes that a person considers as relevant. The end may be designated
as A and B.
2. Assign utility of 0 to A (the lowest outcome) and utility of 1 to B (the highest outcome).
3. Determine the utility associated with any intermediate value by the following process:

(a) Present the individual with two alternatives. The first alternative of the intermediate
value X, the utility of which is to be determined, second alternative consists of a
lottery which has two possible outcome A and B with probabilities P1 and P2 attached
to them (P1 + P2 = 1). Ask the individual to choose one of the alternatives.
(b) If the individual chooses the first alternative, revise the second alternative makes it
more attractive i.e., the value of P2 should be increased. If the individual chooses the
second alternative, raise the same to less attractive i.e., value of P2 should be decreased
and the value of P2 should be increased.
(c) Continue the revision process laid down in (b), till the individual indifferent to both
alternatives.
(d) When the individual becomes indifferent to both alternatives, the utility of A is
simply the value of P2.
4. Obtain the utility values of several intermediate outcomes and plot the utility function.

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