Page 201 - DMGT405_FINANCIAL%20MANAGEMENT
P. 201
Unit 9: Capital Budgeting
Once the utility curve of the decision-making unit is obtained, the expected utility project is Notes
measured as follows:
1. Define the probability distribution of NPV.
2. Calculate the expected utility by using utility function.
u (NPVi) Pi
where u(NPV ) = utility of the ith positive NPV
i
P = Probability of ith possible outcome
I
Example: Let the probability distribution of NPV for a project be as follows:
NPV –10,000 0 20,000 30,000
Probability 0.1 0.3 0.4 0.2
Let the utility for money for the decision maker be as follows:
Money ( ) Utility
– 20,000 0
– 10,000 0.10
0 0.35
+ 10,000 0.50
+ 20,000 0.68
+ 30,000 0.85
+ 40,000 0.90
+ 50,000 1.00
Hence the expected utility of the project is:
= 0.10 × 0.1 + 0.35 × 0.3 + 0.68 × 0.4 + 0.85 × 0.2
= .01 + 0.105 + 0.272 + 0.17 = 0.557
Evaluation: This method is superior to other methods of risk adjustments since it offers an
approach for incorporating the risk factor consistently. However, the following are the problems:
1. It is difficult to obtain the utility functions of an individual i.e., translating the risk attitude
of an executive requires patience and ingenuity on the part of the analyst.
2. Utility function of the decision-maker may not remain stable over time, since it is dependent
on the organization financial position.
3. There is no acceptable way of determining the utility function of a group. (Since investment
decisions are group decisions)
Hence, utility theory is not very useful for investment decisions where the cost and benefits are
spread over long period. It is, however, a potential tool for short-term investment.
Self Assessment
Fill in the blanks:
14. Business firms using Payback method usually prefer ……………..payback.
15. Under Certainty equivalent approach method, risk element is compensated by adjusting
cash inflows rather than adjusting the………………...
16. A ………………..approach is a pictorial representation in tree form along with branches of
the magnitude, probability and inter relationship of all possible outcomes.
LOVELY PROFESSIONAL UNIVERSITY 195
