Probability the language of uncertainty Flashcards
Net Present Value (NPV)
is a financial-calculation technique used to value a series of future cash in-flows (revenues) and cash out-flows (costs) by discounting them back to the present.
The danger is that in many business decisions under uncertainty are:
_____ single scenario estimates are used instead of probability estimates
No single number estimates can:
____ account for downside risk and upside opportunity
Single scenario estimates are
____ inadequate to reach sound conclusions
Probability
is the best way to account for uncertainty
Decision-relevant information
________ is obtained from subject matter experts (SMEs) and probabilities are used to model uncertainty
Primary Source
Obtained from interviewing SMEs using probability-encoding procedures
•Uncertainty of a continuous variable is modeled using discrete approximation methods
Secondary Source
•Obtained from SMEs and/or from observed/historical data
•Uncertainty of a continuous variable is modeled using
odiscrete approximation methods when n > 10
oMonte Carlo simulation (uniform) when n < 10
Information obtained on continuous variables
_____ often results in a s-shaped cumulative distribution function (CDF).
Subject Matter Experts
______ often overestimate their expertise resulting in a probability distribution that is too narrow.
Overconfidence
is failing to collect key factual information because the subject matter expert is too sure of their judgment
Motivating, Structuring, Conditioning, Encoding
Probability-encoding procedures
Motivating
Introduce task and identify motivational biases
Structuring
Establish definition of variable and assumptions
Conditioning
Counteract cognitive biases
Encoding
Develop probability distributions
Examples of Conditioning
Divide and conquer
Influence diagram
Elicit ranges
Encoding
Face-to-face > phone call > email > questionaire
probability-encoding process
Used to assess market size from a subject matter expert.
Motivating
Process step where Company is deciding whether to introduce a new product
Structuring
Process step where Market size in USD 5-years from now
Conditioning
Process step where Worst-Case Scenario: $50 Million
Best Case Scenario: $500 Million
