Module 2

1
Module 2

• Modeling Decisions
• ELEMENTS OF DECISION PROBLEMS

2
Learning Objectives

• Elements of decision situations
• Money and decision problems

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Elements of Decision Problems

• Values and objectives
• Decisions to make
• Uncertain events
• Consequences

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Values and Objectives

• Values things that matter
• Objective what you want to achieve

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Values and Objectives

• Values create decision situations
• Values compel the need for objectives

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Values and Objectives

• Each decision situation involves a specific
  context
• Context influences the viable objectives
• A decision model must include all of the relevant
  objectives

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Decisions to be Made

• At least two alternatives required.
• Doing nothing may be a viable alternative
• In many cases, several sequential decisions are
  necessary

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Uncertain Events

• Important decisions must often be made without
  knowing the future
• Potential results from resolving uncertain events
  are outcomes
• Relevant outcomes have impacts on objectives

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Consequences

• The end results of decision making are
  consequences
• For multiple objectives, a consequence applies to
  each objective
• Consequences require planning horizons
• Values of consequences must be determined

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Elements of Decision Problems

• Values and objectives
• Decisions to make
• Uncertain events
• Consequences

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Decision Elements Relationships

• Fig- 2.4 from Page 29

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Money and Decision Problems

• Money is medium of exchange
• Making money can be an objective
• Money is frequently a surrogate

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Money and Trade-Offs

• Making money may not be maximized
• Making money may be traded off
• Time is an important trade off

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Time Value of Money

• Current value of future money called present
  value
• Present value uses principle of compound interest

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Time Value of Money

• Invest 100 at 10 compounded annually
• Year 1 100 x 1.1 110.00
• Year 2 110 x 1.1 121.00
• Year 3 121 x 1.1 133.10
• Present Value (PV) of 133.10 three years hence
  is 100 at 10 compounded annually

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Time Value of Money

• Let
• r interest rate
• n number of time periods
• x future cash flow
• Then PV (x, n, r) x/(1r)n or x(1r)-n
• For example,
• PV (133.10, 3, 0.10) 133.10 / (10.10)3
  100

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Time Value of Money

• Extension of concept to sequence of cash flows
• Cash flow values may be the same or different
• Determine individual PVs and then sum
• PV

n
xi / ( 1 r )i
i 0
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Time Value of Money

• Net Present Value (NPV) is difference between PV
  of negative and positive cash flows
• NPV value
• lt 0 undesirable
• 0 breakeven
• gt 0 desirable

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Time Value of MoneyExample

• Suppose you invested 1,000 in a mutual stock
  fund for three years. From fund dividends and
  capital gains, you received 100 the first year,
  nothing the second year, and 200 the third year.
  At the end of the third year, you also liquidated
  your holdings, receiving 1,000 in proceeds. If
  you could have invested the 1,000 in a different
  fund earning 10 compounded annually, was your
  mutual stock fund investment a wise choice?

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Time Value of MoneySolution

• NPV -1000

100
( 200 1000)


1.10
1.11
1.13
- - 1000.00 90.91 901.58 7.51

• NPV lt 0 not a wise choice

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Summary

• Basic elements of decision problems
• Values and objectives
• Decisions to be made
• Uncertain events
• Consequences
• Money and decision problems