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Summary LU6: Expected value theory and decision trees
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Luthando Zulu: 17599770Finance 2B – FINM6212
LU6: Expected value theory and decision trees
Introduction:
Due to the nature of the business world, most decisions have to be made under conditions of uncertainty.
The theories of expected value and decision trees are designed to assist with decision-making under
these circumstances.
Below is a list of definitions that will be used in this learning unit:
Expected value Sum of the weighted values associated with a decision.
Certainty Circumstances where all the outcomes are known. This means that the decision-
maker is in possession of perfect information. Decision making is without risk.
Uncertainty These refer to circumstances where the outcome is unknown, and the probabilities
of the possible outcomes cannot be assigned. This means that the decision maker
is in possession of imperfect information. Decision-making can, therefore, carry
some form of risk.
Risk Refers to the probability of damage, liability or other negative consequences
arising from internal or external vulnerabilities which may be mitigated through
proactive risk management.
Probability The likelihood that an event, condition or outcome will occur.
Attitude towards risk:
Individuals and decision-makers, by their nature, will have different attitudes toward risk.
Individuals have one of three attitudes when it comes to risk:
Risk taker An individual who is fearless of risk and
uncertainty and is willing to take a chance in the
hope of achieving a highly favourable outcome.
Risk averter An individual who is fearful of risk and prefers a
more certain outcome.
Risk neutral An individual who is indifferent to alternatives that
yield an equal return and will vouch for the
alternative that yields a higher average profit in
the long-term.
Expected value theory:
A mathematical tool that considers the possible outcomes as well as the probability of occurrence of each
alternative presented to management in the decision-making process. The expected value of a decision is
the sum of the weighted values outcomes associated with a decision. The weightings represent the
probabilities that each outcome will occur.
The expected value formula is calculated as follows:
EV =∑ (Pr ¿ ¿1 x value1)+(Pr ¿ ¿ 2 x value2 )+(Pr ¿ ¿ 3 x value3 ) …+(Pr ¿ ¿ n x value n )¿ ¿ ¿ ¿
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