Risk and uncertainty 378 Summary

Risk and uncertainty:

Decision-making under circumstances of risk and uncertainty:
 Up to now single set of information, for example: should the project be discontinued,
R20 000 in fixed overheads will be saved.
 What happens if there is a series of possible outcomes with different possibilities?

Example:
Probability distribution (when you see these words it is a hint that the question refers to
risks and uncertainty) for events or “states of nature” (uncontrollable by decision-maker).
Probabilities can either be objective such as tossing a coin or throwing a die, whereas most
business decisions are subjective because no two individuals will assign the same
probabilities to an expected outcome.

35% 45% 20%
POOR AVERAGE GOOD
Product A 1000 1500 2000
Product B 500 750 1000
Contribution per unit A= R50
Contribution per unit B = R40
Total Fixed costs = R80 000

Decision-making under circumstances of risk and uncertainty:
 Man Acc 378 purposes – work with EXPECTED VALUE for decision-making
purposes:
o If uncertain or more than one possible outcome, always use the expected
value.
 Expected value = ΣpX
p = probability of outcome
x = value of outcome


Decision?

19730

Decision = should this branch be purchased or not? Purchase price is R20 000.
 Maybe there is a small loss in year 1, but there was large capital expenditure which
will lead to a larger profit in future years.
Expected profit based on expected values = (1 425 x R50) + (712 x R40) – R80- 000 = R19
730
Risks (mention non-financial factors)


Expected profit based on expected values = R19 730
Best outcome = (2 000 x R50) + (1000 x R40) - R80 000 = 60 000 (20%)
Most probable outcome = (1 500 x R50) + (750 x R40) - R80 000 = 25 000 (45%)

, Worst outcome = (1 000 x R50) + (500 x R40) - R80 000 = -R10 000 (35%)

UNCERTAINTY LEADS TO RISK!
 The expected value is R19 730.
 Should you buy or not?
o The chances of incurring a loss are 35%
 If management are risk adverse, then management will not buy because it is too risky
(they would prefer the less riskier option as most investors would)
 But if management are risk takers, although there is a 35% chance of a loss, they also
recognise that there is a 20% chance of making a R60 000 profit (maximum profit)
and will therefore accept such a risk (prefer more riskier option)
 If there is not enough information in the question, still address management’s attitude
to risk:
o The higher the risk, the lower the rewards
o The lower the risk, the lower the rewards


Calculate the relevant benefit (cost) should the branch be
discontinued
Decision = should this branch be discontinued or not?
Should this branch be discontinued if there is a 40% probability that 60% of this branch’s
products (in the same ratio as mentioned in the probability distribution) will be sold by other
branches within the entity? There is a 60% probability that none of the products will be sold
by the other branches. If the branch is discontinued, all fixed costs (R80 000) can be saved.
 40% chance that there is a 60% contribution (retain)
 60% chance that there is a 0% contribution (retain)

Decision-making under circumstances of risk and uncertainty:
BENEFIT IF
CONTINUE DISCONTINUE DISCONTINUED

99 730.00 29 935.2 -75 794.80
Contribution

-80 000 -0.00 80 000.00
Fixed costs

4 205.20
If there is uncertainty – calculate the expected value!!
Expected contribution if continue = (1 425u x R50) + (712u x R40) = R99 730

Expected revenue within the entity should the branch be discontinued: