DECISION ANALYSIS

INTRODUCTION:

A decision is defined as the selection by the decision-maker of an act, considered to

be best according to some pre-designated standard, from among the several
available options.

Decision-making problem:

There are certain essential elements which are common to all such problems. These
are:

 Course of action: A decision is made from a set of defined alternative

courses of action. These are also called actions, acts or strategies.

 State-of-nature: These are the consequences of any courses of

action are dependent upon certain factors beyond the control of the
decision-maker.

 Uncertainty: This is indicated in terms of probabilities assigned to the

occurrence of events.

 Payoff: It measures the net benefit to the decision- maker that

accrues from a given combination of decision alternatives and events.

 Payoff table: Suppose the problem under consideration has n

possible events (state of nature) denoted by E1, E2… En and m alternatives
acts (strategies) denoted by A1, A2, …..Am. Then the payoff corresponding
to strategy Aj of the decision-maker under the event (state-of-nature) Ei will
be denoted by aij (i=1,2…..,n;j=1,2,….,m).

DECISION-MAKING PROCESS:

Step 1: Determine the various alternative courses of action from which the final
decision is to be made.

Step 2: Identify the possible outcomes called the state-of-nature for the decision
problems. The events are beyond the control of the decision-maker.

Step 3: Determine the payoff function which describes the consequences resulting
from the different combinations of the act and events.

Step 4: Construct the regret opportunity loss table. An opportunity loss occurs due
to failure of not adopting best available course of action.The opportunity loss values
are calculated separately ofr each outcomes (state-of –nature) by first locating the
most favorable course of action for that outcomes and then determining the
departure of the payoff value for that course of action and payoff value for the best
possible course of action that could have been selected.

Consider a fixed state-of –nature Ei (i=1, 2 ,3………..n) for which the payoff
corresponding to the n courses of action are given by Pi1, Pi2,…….Pm. Let M1 be
the payoff for the least possible occur of action. The opportunity loss table will be
shown as follows:

State-of-nature Conditional opportunity loss (decision alternatives)

Events
A1 A2 A3 ….. Am

E1 M1 – p11 M1 – p12 M1 – p13 …..

M1 – p1m

E2 M2 – p21 M2 – p22 M2 – p23 ….. M2 –

p2m

E3 M3 – P31 M3 – p32 M3 – p33 ….. M3 –

p3m
. . . .
. . . .
En Mn – pn1 Mn – pn2 Mn – pn3 ….. Mn –
pnm

DECISION-MAKING ENVIRONMENT:

Decision-making is used to determine optimum strategies where a decision-maker

is faced with several decision alternatives. We may come across several decision-
making situations:

 Decision under certainty: Whenever there exists only one outcome

for a decision, we are dealing with the category. Examples-linear
programming, transportation etc.

 Decision under conflict: In many cases neither state-of –nature are

completely known nor are they completely uncertain. Partial
knowledge is available and therefore it may be termed as decision-
making under `partial uncertainty`. An example of this is the situation
of conflict involving two or more competitors marketing the same
product.
  Decision under uncertainty: These refer to situations where more
than one outcome can result from any single decision.

 Decision under risk: This refers to decision situations wherein

decision-maker chooses from among several possible outcomes where
probabilities of occurrence can be stated objectively from the past
data.

DECISIONS UNDER UNCERTAINTY:

Under uncertainty, only payoffs are known and nothing is known about the
likelihood of each state of nature.

1. THE LAPLACE PRINCIPLE

The Laplace uses all the information by assessing value equal probabilities to the
possible payoffs for each action and then selecting that alternatives which
corresponds to the maximum expected payoff.

The basic steps of this are :

Step 1: Assign equal probabilities (1/n) to each payoff of a strategy( having n

possible payoffs)

Step 2: Determine the expected payoff value for each alternatives.

Step 3: Select that alternatives which corresponds to the maximum of the above
expected payoffs.

2. THE MAXIMIN OR MININMAX PRINCIPLE

The maximin is based upon the “ conservative approach” to assume that the worst
possible is going to happen. The decision maker consider each strategy and locates
the minimum payoff for each; and then select that alternatives which maximizes the
minimum payoff.

This consist of two steps:

Step 1: Determine the minimum assured payoff for each alternative.

Step 2: Choose that alternative which corresponds to the maximum of above

minimum payoffs.

When dealing with the costs , the maximum cost associated with each alternative
criterion used is the Minimax and carried out in two steps:

Step 1: Determine the maximum possible cost for each alternative.

Step 2: Choose the alternative which corresponds to the minimum of the above
costs.

3. THE MAXIMAX OR MINIMIN PRINCIPLE

The maximax is based upon “extreme optimism “.The decision maker selects that
particular strategy which corresponds to the maximum of the maximum payoffs for
each strategy.

The maximax consist of the following steps:

Step1: Determine the maximum possible payoff for each alternative.

Step 2: Select that alternative which corresponds to the maximum of the above
maximum payoffs.

4.THE HURWIEZ CRITERION

:Hurwiez Criterion stipulates that a decision maker`s view may fall somewhere
between the extreme pessimism o maximum criterion and the extreme optimism of
the maximum criterion. The criterion provides a mechanism by which a balance
between extreme pessimism and extreme optimism is made b y weighing them
with certain degrees of optimism and pessimism.

The basic steps for this criterion is summarized as

Step1: Choose an appropriate degree of optimism (or pessimism) of the decision-

maker.

Step2 : Determine the maximum as well as minimum payoff for each alternative
and obtain the quantities.

DECISION UNDER RISK:

When a decision maker chooses from among several options whose probabilities of
occurrence can stated, he is said to take decision under risk. The probability of
various outcomes may be determined objectively from past data. However, past
records may not be available to arrive at the objective probabilities. In many cases
the decision-maker may, on the basis of his experience and judgment, be able to
assign subjective probabilities to the various outcomes. The problem can then be
solved as decision problem under risk.

Under condition o risk, the most popular decision criterion for evaluating the
alternatives is the expected monetary value or expected opportunity loss of the
expected payoff.
Expected Monetary Value (EMV) Criterion:

The EMV for a given course of action is the expected value of conditional payoff for
that action. The conditional payoffs are obtained for each action by considering
various act-event combinations. The EMV criterion may be summarized as :

Step1: List conditional profit for each act-event combinations, along with the
corresponding event probabilities.

Step2: For each act determine the expected conditional profits.

Step3: Determine EMV for each act.

Step4: Choose the act which corresponds to the optimal EMV.

INVESTMENT ANALYSIS

INTRODUCTION

Every individual or firm wishes to know how 'best' to invest money to attain the
maximum gain. To achieve this objective, a proper investment analysis is to be
made. It
involves the consideration of investment proposals, estimation of their cash flows,
evaluation of cash flows, selection of the proposals based on some criterion and
finally the continuous revaluation of these proposals (projects).

This chapter is focused on financial decision-making problems arising out of an

investment decision, and provides detailed steps necessary for the analysis of such
problems. The chapter begins with a consideration of the time value of money,
followed
by the investment analysis, i.e., the question of making capital budgeting decisions.

Thereafter, interrelations between cost, revenue, volume, and the profit planning
(i.e., break-even analysis) have been discussed.

TIME VALUE OF MONEY

One of the basic concepts of finance is the notion that money has time value. This is

because money today is more valuable than the same amount at 'some future date.
We can
alw ays put available funds to some use and" make them grow into higher sums, so
that a
larger sum would be available later on. A rational decision-maker would not value
the
opportunity to receive some amount of money now, equally, with the opportunity to
have
the same amount of money at some future date. This phenomenon is known as the
decision
maker's 'time preference of money'.

The time preference for money is generally expressed by means of an interest rate.
For
exam pie, if the time preference rate of an individual is 10%, he may forego the
opportunity
of receiving Rs. 100 now if he' is offered Rs. 110 after one year. There, amounts to
pay him
the current principal (Rs. 100) plus the interest that would accrue on it after one
year
@ 10% p.a. Like individuals, firms also have time preference (or discount rate).
They use
this rate in evaluating the alternative decisions.

Compound Value

Consider the situation, when the investments involve more than one year.
Let the
interest, as it becomes due, is added to the principal, and the amount, thus,
obtained forms
the principal for the next time period. Then, the mode of interest
computation is called
Compound Interest. The time period after which the interest is added each
time to the
principal to form the new principal is called Conversion Period and amount
received after
the last conversion period is called the Compound Value. The difference of
the compound
value and the original sum borrowed is the amount of Compound Interest for
given
can version periods.

Let P be the principal. r the rate of interest in percentage per conversion

period, and
J7 is the number of conversion periods. Then the amount after Ist conversion
period will
be P + P x r, i.e., P (I + r). Similarly, compound amount after 2nd conversion
period will be P (I + r) + P (I + r) x r, i.e., P (I + r)2. In general, compound
amount after nth
conversion period = P (I + r) n.

The factor (I + r)n is also sometimes called the accumulation factor.

Present Value

The present value (PV) is the amount of money that represents the sum of
principal
and interest if P (i.e., principal) is required to be invested now at a certain
rate
compounded over a number of time periods at a specific rate for each time
period.

The present value of the amount A (n) due at the end of n interest periods at
the rate
of r (in percentage per conversion period) may be obtained by solving for P,
the following
A (n) = P (1 + r)^n or P = A (n) x, (I + r)^-n
Continuous Compounding

In most of the investments; the interest is payable quarterly, half-yearly or at

the end
of some other fraction of the year. Let the annual year be composed of f
such periods.
Then, an n-year period shall be equivalent c o n x f periods. If an amount P is
invested at
the interest rate r % per IIf year, the compound value at the end of 11 years
shall be

A (n) = P ( 1 + r / f)^ n f

By continuous compounding we mean compounding over an infinitely large

number of
periods (i.e., f infinity ). An example of it could be the rate of return that
a firm earns on its
initial investments, since it enables it to receive continuous inflow of earnings
throughout
the year or over a specified time horizon.

ANNUITIES AND SINKING FUND

Instead of investing a lump sum amount initially, once may invest a constant
amount
annually (or monthly) or at equal intervals for a designated period of time.
The investment
is generally assumed to be made at the end of each period. The constant
periodic sums are
called annuities. A recurring deposit amount in Post Office/Bank, payment of
insurance
premium, etc., are the examples of annuity. It may be noted that-
(a) The size of each payment of an annuity is called the periodic payment.

(b)An annuity which is payable forever, i.e., which never terminates is called
perpetuity.

(c)The total time from the beginning of the first payment period to the end of
last
payment period is known as the term of annuity.

(d) The algebraic sum of payments and the accumulated interest is known as
the amount of annuity.

(e) The present value of an annuity is the sum of the present values of its
installments.

Amount of an Annuity

The amount of annuity refers to the terminal value of the sequence of

payments,
including principal and compound interest, at the end of the term of annuity.
To obtain
the amount of annuity, let P = the periodic payment. r = the rate of interest,
and
n = the interval, or the term of annuity, or the number of payments.

The first payment, being made at the end of the first time period, shall carry
accumulated interest for (n - I) time periods, the second one would similarly
carry
interest for (n - 2) time periods, and so on. The last payment would not carry
any interest,
because it is made at the end of the term. Thus, the amount of an ordinary
annuity of Rs. p
per period for n periods at the rate of r per period is given by
A(n, 1') = p(1 + r)^n-I-+ p(1 + r)^n-2 + ... + p(l + 1') + P
Multiplying this equation on both sides by (I + r), we get

(I + r)A(n. 1') = p(1 + r)n + p(l + r)n-I + ... + pel + 1')2 + p(1 + 1')
On subtraction, these equations yields

[(1+r)-1]A (n,r)=p(1+r)^n-p

A (n, r) = p[(1+r)^n-1] / r

Types of Annuities

In general, there are two types of annuities, namely annuity certain and
annuity
contingent.

1. Annuity Certain. When payments are to be made unconditionally for a

certain
fixed period of time. The annuity is known as annuity certain. This type of
annuity can. be
further sub-divided into following three categories:

(a) Annuity Immediate. If the payments fall due at the end of each period,
the
annuity is called an immediate or ordinary annuity.

(b) Annuity Due. If the payments fall due at the beginning of each period, the

annuity is called annuity due. In this annuity, the first payment falls due at
the
beginning of first interval, the second payment falls due at the beginning of
the·
second interval, and so on. Premium on life insurance policies illustrate the
point.
(c) Deferred or Reversionary Annuity. If the money is allowed to accumulate
for a
certain period and the payments begin after the lapse of that period, the
annuity is
called deferred or reversionary annuity. For example, when the house
building
loan is granted to a person, the repayment of loan begins after the expiry of,
may
be, a year or two from the date of grant of loan.

2. Annuity Contingent. Annuities, in which the payments are to be made

till the
happening of an event such as construction of house building. marriage of a
girl, are the
examples of annuity contingency.

Present Value of an Annuity. The present value or capital value of an annuity

'A' is
the sum of the present values of all payments. It represents the amount that
must be
invested now to purchase, the payments due in future.

It may he noted that the interest is compounded at the end of each payment
period.
Let us, now, consider an annuity of 1 1 payments of y (rupees) each, where
the interest
rate per period is r and the first payment is due one period from now. Then,
the present
value of the annuity is given by

Pv= x(1+r)^-1 + x(1+r)^-2 +…… + x(1+r)^-n

Multiplying this equation on both sides by (I + rt' and then subtracting it from
the
above equation. we get

PV - PV(I + r)^ -1 = x(1 + r)^-I - x(1 + r)^ -n+ 1

Hence, pv = x*

Present Value of a Perpetual Annuity For a perpetuity, there is no end to

the
periodic payments, Under the conditions, therefore.. /1 -7 00, This
implies that
(I + r)^ -n-7 0, So, the present value of a perpetuity of Rs, x per year @ r %
per annum
is given by

PVP= (A / r)
Where PVP = present value of perpetuity.
A = constant annual cash flow.
r = rate of interest.

Present Value for a Deferred Annuity For an annuity in respect of which

the first
payment is scheduled to begin after the lapse ofa certain time period, the
present value
can be obtained in a similar way as for the ordinary annuity. To -illustrate, let
the annuity
begins in 'I' years from now (so that the first paym entwould, as usual, be
made at the end
of the first year at that, time), the 'present value of the successive payments
would be
x (I +r)^ -(1 +I), x (I + r)^-(l+2), and so on.

Thus,
PV = x (I + r)^-i+1 + x (l + r)^-1+2 + ... + x (I + r)^-i+n

To obtain the value of PV we first multiply this equation by (I + r) and then

subtract
the above equation from it. -Thus, we get

PV=x/r(1+r)^-1 [1-(1+r)^-n]

Sinking Fund

A sinking fund is a fund that is created for a sequence of periodic payments

over a
time period at a specified interest rate, The amount in such a fund is usually
used for
repair of buildings, replacement of an equipment, expansion of an
enterprise, and so on,

If A is the amount to be saved, and P, the periodic payment: then size of the
sinking
fund is computed by using the following formula

A = R [(1+i)n-1]/i R = Ai/(1+i)n -1

R = Ai/(1+i)n -1

R : periodic payment.

A : periodic payment R is required to accumulate a sum of A dollars.

n: number of periods.

i: interest rate.

METHODS OF INVESTMENT ANALYSIS

An efficient allocation of capital is one of the most important functions of a

financial
management. This function involves the firm's desire to commit its funds in
long tern
assets and other profitable activities. Such investment decisions are of
considerably important, because they influence the wealth of the firm,
determine the size, set up the pace and direction of its growth and affects
business risk.

Investment decisions of a firm influence its wealth-it will increase if the'

investment
proposals are profitable, otherwise it would decrease. Now, to evaluate an
investment
proposal the study of the following components is necessary:

a) The initial cash outflow.

b ) The returns (or net cash-inflows calculated on yearly basis) over the
economic life
of the asset.

(c) The economic life of the asset. Economic life is usually shorter than
durable life
due to technological advancements.

(d) Minimum return desired on such investment, called "cut-off point".

The most widely used methods of evaluating an investment proposal can be

grouped
into the following two major categories:

I. Traditional Methods these include (a) Payback Period method, and (b)
Average
Rate of Return method.

2. Discounted Cash Flow (DCF) Methods These include (e) Net Present
Value
(NPV) method, (d) Internal Rate of Return (IRR) method, and (e) Discounted
Payback Period method.

(a) Payback Period Method Payback period is the number of years

required to
recover the cash invested in a project. If the annual cash inflows are same,
.the payback
period can be computed dividing the cash invested by the annual cash
inflow; if unequal,
it can be calculated by adding up the cash inflows until the total is equal to
the initial cost
invested.

Illustration, A project requires a cash outlay of Rs. 60.000 and yields an

annual cash inflow of
R s .12.000 For 7 years. What is its payback period?

(p) = Cash outlay (P)/ average met cash inflow per year(R)

60,000/12000 = 5 years

It may be noted that the proposal will be accepted, only if payback period is
5 years or less.

(b) Average Rate of Return Method The average rate of return is an

accounting
method. It is calculated as the ratio of the average annual profits, after
taxes, to the average investment in the project. For instance, if the average
annual book profits (after
taxes and depreciation) are estimated at Rs. 20;000 and net investment for a
new equipment is Rs. 1,00.000; then the average rate of return would be

Rs. 20,000/Rs. 1,00,000', i.e., 0.20 or 2Q%.

After computing the average rate of return, it is compared with a required
rate of
return to determine whether a particular project should be accepted or
rejected.

(c) Net Present Value (NPV) Method This method takes into account the
time value
of money. It correctly postulates that cash flows arising at different time
periods differ in
value and are comparable only when their equivalent ‘present values’ is
found out.

The NPV of a proposal is computed by the following relation:

NPV = PV of cash inflows - PV of cash outflows

The proposal is accepted, if NPV > 0, otherwise it is rejected. The PV of all

cash
outflows is determined using some pre-determined discounting rate, which
generally equals
the cost of capital (minimum rate of return or the interest rate).

Remark I. The NPV method can be used to select between mutually exclusive
proposals by considering
whether the incremental investment generates a positive NPI'. Using this
method, the proposal would be ranked in order of theirNPV values.

(d) Internal Rate o r Return (IRR) Method. The internal rate of return is
the rate at
which. an investment. is repaid by proceeds from a project. In other words, it
is the rate that
c:quates the present value of the 'cash inflows with the present value of cash
outflows of an
investment. It is determined by using the following formula:
 where CF represents that Cash Flow generated in particular time
period
N represents the last time period.
R represents IRR value.

T h e computed IRR is compared with the required rate of return, If the

calculated rate
exceeds the required rate, the proposal is accepted; otherwise it is rejected.

Note: The value of r in the above equation is determined by trial and error.
We select any rate of interest to compute PI' or cash inflows. If the calculated
PV of cash inflows is lower than the PV of cash outflows a lower rate interest
is to be tried. On the other hand. a higher rate should be tried. if the PI' of
cash inflows is higher than, the PI' or cash outflows, The process is to be
repeated till the NI'V becomes zero.

Remark I: may be observed that the IRR formula is same as used for the NPV
method with the difference
that in the NPV method, the required rate of return 'is assumed to be known
and then the NPV is calculated whereas in the IRR method the value of r
has to be determined such that the NPV is zero.

(c) Discounted Payback Period Method The payback period is defined as

the
number of years required to recover the original investment. In the case of
discounted payback period we consider the discounted present values of
future cash inflows and find
out the number of years required to recover the initial investment. If
discounted payback
period is less than the desired payback period, the project is accepted. To
illustrate, let us
consider the folinwif1.g investment proposal with an initial investment of Rs.
24.000.

Cash inflow PV factor Discounted PV Cumula

Year
tiv
(Rs.) @ 10% (DPV) (Rs.) DPV (Rs.)

1 8000 0.909 7272 7272

2 10000 0.826 8260 16530
3 10000 0.751 7510 24040
4 12000 0.683 8196 32236
5 10000 0.621 6210 38446

The number of years required to recover the initial amount is 3 years. Hence
the
discounted pay-back period is 3 years.

Ken Group of Industries

 Chance node 1 Low demand (8
lakh*0.4 = 3.2lakh)

Medium demand
(18 lakhs*0.3=5.4lakh)
Build large plant
10 lakhs
Large demand
(22lakhs*0.3=6.6lakhs)

Build small
plant 4lakhs

Decision node 1 Low demand

(meet demand) no expansion required (4*0.4=1.6lakh)

Chance node 2 further

expansion for medium demand (0.5*16=8lakhs)

Decision
node2

Large demand

(0.5*19=9.5lakhs)
Colum
n1 Column2 Column3 Column4 Column5
sr. no. Decision Returns Earned Total Returns Decision
return earned -
investment

for small demand (8*0.4=3.2lakhs)

Build Large for medium demand 15.2lakhs - 10lakhs =

1 plant (18*0.3=5.4lakhs) 5.2 lakhs SELECT

for large demand

(22*0.3=6.6lakhs)

if small demand meet demand

(4*0.4=1.6lakhs)

for further medium and large

demand
Build small 19.1lakhs - (4+4+8)
2 plant =3.1lakhs REJECT
expansion for medium demand
(16*0.5=8lakhs)

expansion for large demand

(19*0.5=9.5lakhs)

From both th options we can observe that the action 1 is more profitable. So
the company should go ahead with building large plant as it involves less
cost and more profit.