Risk and Uncertainty

Question 1

What are the advantages and disadvantages of Expected values?

Answer 1

Advantages

• Takes risk in to account - using each probability.
• Result is a single number - easier decision making
• Calculations are relatively simple.

Disadvantages

• Probabilities are subjective
• EV is a weighted average so is generally relevant for one off projects
• EV gives no indication of risk
• EV may not correlate to any of the actual possible outcomes.

Question 2

What are the key things to be aware of with decision trees?

Answer 2

Decision trees are always drawn from left to right and will incorporate the following symbols:

• Square - represents a decision point
• Circle - represents a chance point, branches coming away from this point will have probabilities attached.

The tree is evaluated from left to right carrying out two actions:

1. Calculate expected value at each chance point.
2. Choose best option at each decision point.
3. Recommend course of action to management

Question 3

What is the value of information?

Answer 3

Value of information = expected profit outcome with the information less expected profit outcome without the information.

Consider what outcomes would be chosen without information and with information the value is the difference between the two.