1 Module 2 Modeling Decisions ELEMENTS OF DECISION PROBLEMS

2 Learning Objectives Elements of decision situations Money and decision problems

3 Elements of Decision Problems 1.Values and objectives 2.Decisions to make 3.Uncertain events 4.Consequences

4 Values and Objectives Values: things that matter Objective: what you want to achieve

5 Values and Objectives Values create decision situations Values compel the need for objectives

6 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

7 Decisions to be Made At least two alternatives required. “Doing nothing” may be a viable alternative In many cases, several sequential decisions are necessary

8 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

9 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

10 Elements of Decision Problems 1.Values and objectives 2.Decisions to make 3.Uncertain events 4.Consequences

11 Decision Elements Relationships Fig- 2.4 from Page 29

12 Money and Decision Problems Money is medium of exchange Making money can be an objective Money is frequently a surrogate

13 Money and Trade-Offs Making money may not be maximized Making money may be traded off Time is an important trade off

14 Time Value of Money Current value of future money called present value Present value uses principle of compound interest

15 Time Value of Money Invest $100 at 10% compounded annually –Year 1: $100 x 1.1 = $ –Year 2: $110 x 1.1 = $ –Year 3: $121 x 1.1 = $ Present Value (PV) of $ three years hence is $100 at 10% compounded annually

16 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) = / (1+0.10) 3 = $100

17 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 = 0 x i / ( 1 + r ) i

18 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

19 Time Value of Money Example 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?

20 Time Value of Money Solution NPV = $ ( ) = = $7.51 NPV < 0 = not a wise choice

21 Summary Basic elements of decision problems – Values and objectives – Decisions to be made – Uncertain events – Consequences Money and decision problems