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Module 2
Modeling Decisions
ELEMENTS OF DECISION PROBLEMS
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Learning Objectives
• Elements of decision situations
• Money and decision problems
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Elements of Decision Problems
1. Values and objectives
2. Decisions to make
3. Uncertain events
4. Consequences
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Values and Objectives
• Values: things that matter
• Objective: what you want to achieve
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Values and Objectives
• Values create decision situations
• Values compel the need for objectives
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Values and Objectives
• Each decision situation involves a specific context
• Context influences the viable objectives
• A decision model must include all of the relevant objectives
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Decisions to be Made
• At least two alternatives required.
• “Doing nothing” may be a viable alternative
• In many cases, several sequential decisions are necessary
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Uncertain Events
• Important decisions must often be made without knowing the future
• Potential results from resolving uncertain events are outcomes
• Relevant outcomes have impacts on objectives
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Consequences
• The end results of decision making are consequences
• For multiple objectives, a consequence applies to each objective
• Consequences require planning horizons
• Values of consequences must be determined
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Elements of Decision Problems
1. Values and objectives
2. Decisions to make
3. Uncertain events
4. Consequences
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Decision Elements Relationships
• Fig- 2.4 from Page 29
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Money and Decision Problems
• Money is medium of exchange
• Making money can be an objective
• Money is frequently a surrogate
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Money and Trade-Offs
• Making money may not be maximized
• Making money may be traded off
• Time is an important trade off
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Time Value of Money
• Current value of future money called present value
• Present value uses principle of compound interest
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Time Value of Money
• Invest $100 at 10% compounded annually– Year 1: $100 x 1.1 = $110.00– Year 2: $110 x 1.1 = $121.00– Year 3: $121 x 1.1 = $133.10
• Present Value (PV) of $133.10 three years hence is $100 at 10% compounded annually
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Time Value of Money
• Let:– r = interest rate– n = number of time periods– x = future cash flow
• Then PV (x, n, r) = x/(1+r)n or x(1+r)-n
• For example,
PV (133.10, 3, 0.10) = 133.10 / (1+0.10)3 = $100
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Time Value of Money
• Extension of concept to sequence of cash flows
• Cash flow values may be the same or different
• Determine individual PVs and then sum
• PV = n
i = 0xi / ( 1 + r )i
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Time Value of Money
• Net Present Value (NPV) is difference between PV of negative and positive cash flows
• NPV value:– < 0 = undesirable– = 0 = breakeven– > 0 = desirable
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Time Value of MoneyExample
• Suppose you invested $1,000 in a mutual stock fund for three years. From fund dividends and capital gains, you received $100 the first year, nothing the second year, and $200 the third year. At the end of the third year, you also liquidated your holdings, receiving $1,000 in proceeds. If you could have invested the $1,000 in a different fund earning 10% compounded annually, was your mutual stock fund investment a wise choice?
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Time Value of MoneySolution
• NPV = -1000 1.10
+ $100 1.11
+ ( 200 + 1000)1.13
- = - 1000.00 + 90.91 + 901.58 = $7.51
• NPV < 0 = not a wise choice
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Summary
• Basic elements of decision problems– Values and objectives– Decisions to be made– Uncertain events– Consequences
• Money and decision problems
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