E2 - Deal with risk and uncertainty

Question 1

1. different risk attitudes

Answer 1

1. a risk seeker is a decision maker who is interested in the best outcomes no matter how small the likelihood that they will occur.
   - … has the highest standard deviation and also the highest coefficient of variation.
   - this indicates high upside potential as evidenced by the possible outcome of …
2. a risk averse decision maker tries to avoid risk.
   - … has the lowest standard deviation and also the lowest coefficient of variation.
   - this indicates that … is most likely to result in an outcome which is closer to the expected value and therefore has a low downside risk.
3. a risk neutral decision maker will select the strategy that maximises the expected value or benefit.
   - this type of decision maker would ignore both the standard deviation and coefficient of variation.

Question 2

2. benefits of standard deviation

Answer 2

1. calculating the standard deviation of the data will give us a clearer indication of the risk, ie, the directors would know whether the decision suits them given their different risks attitudes.
2. the standard deviation shows how much estimated / actual data is different from the expected value. it tells management how the data is distributed.
3. the result is not affected by extreme values as well.

Question 3

3. interpretation of the pay-off table

Answer 3

1. the payoff table shows a measure of the value or “payoff” of each possible outcome in terms of the decision facing the decision makers.
2. a payoff table can be a useful way to analyse a situation where there is a range of possible decisions and outcomes. a payoff table explains all possible gains/losses and as such is often used in decision-making under conditions of uncertainty.
   - in our case there are_how many options _ and there are how many outcomes / demands. the payoff table shows the level of contribution that would be earned by ** as a result of making each decision depending on the level of outcomes.
3. the value of the table is very much dependent on the accuracy of the market research that has been undertaken.

Question 4

4. maximax approach

Answer 4

1. this means that the decision maker would choose the option which maximises the maximum payoff achievable.
2. this is based on the assumption that the best payoff will occur.
3. this approach is suitable for a decision maker who is risk aggressive and is prepared to choose the decision option which gives the best results if the most beneficial decision outcome occurs even though the chances are small.

Question 5

5. maximin approach

Answer 5

1. this means that the decision maker would choose the option which maximises the minimum payoff achievable.
2. this is based on the assumption that the worst possible outcome will always occur and hence the largest payoff should be chosen from the worst possible outcomes.
3. this approach is suitable for a decision maker who is risk averse and wishes to achieve the best outcome should the worst case happens.

Question 6

6. minimax regret approach

Answer 6

1. this would minimise the maximum regret on the part of the decision maker.”regret” in this context could be regarded as the opportunity loss incurred as a result of making a less than optimal decision.
2. this decision strategy is useful when the decision maker wishes to avoid making a bad decision, ie, for risk averse decision maker.

Question 7

7. expected value approach

Answer 7

1. the decision maker would choose the highest expected value from the decision under this approach.
2. this is suitable for the decision maker who is risk neutral. this approach is suitable for long term decision making if the decision is repetitive and the decision maker has experience regarding the probability of the event happening and its past outcomes.

Question 8

8. potential benefits of expected values

Answer 8

1. expected values are associated with risk neutrality and consider the probability of each possible outcome.
2. the decision information is reduced to and represented by a single number that facilitates decision making.
3. the calculations are relatively straightforward.

Question 9

9. limitations of expected values

Answer 9

1. the expected value is dependent on the estimate of the probabilities which are subjective.
2. as the expected value is a weighted average it is not suited to one-off decisions.
3. the expected value gives no indication of the dispersion of possible outcomes around the expected value, that it, the risk.
4. the expected value may not correspond to any of the actual possible outcomes as it is an average.
5. expected value ignores other non-financial factors that should be considered.

Question 10

10. decision tree

Answer 10

1. since there is risk associated with how successful the product launch will be and therefore the level of demand, we need to calculate and compare the expected values for each outcome.
2. to make a decision using the decision tress we need to work from right to left, starting with the decision…
3. we then work backwards to the decision about whether to … to make each decision we need to look at the decision points (shown by the square boxes), point A is the decision whether to choose option 1 or option 2.
4. based on the information given in the decision tree therefore, the most financially decision to …

Question 11

11. limitations of using this decision tree

Answer 11

1. based on estimates of the cask flow…
2. the probabilities are also estimated. there are a whole range of factors that will affect market reaction to our products such as competition and consumer preference.
3. a decision tree approach to decision making is based on expected values which are weighted averages of all possible outcomes, weighted according to their probability of occurrence. this approach is valid where a project is to be repeated time and time again because the expected value should be the same as the average of the results from all of the occurrences. however, this approach is not valid for a one-off decision such as this.
4. because a decison tree approach uses expected values there is an assumption that the decision maker is risk neutral. this means that the range of possible outcomes and their probabilities are ignored.