Free Essay

Financial Decision Making Under Uncertainty

In: Business and Management

Submitted By pandarg
Words 2924
Pages 12
Arguelles, Amanda Marie Co, Darlene Angelini R. Assignment 2 I. Given:

U  W   e W

Where α is a parameter (1a) To prove that more is preferred than less, we need to show that this individual’s preferences are nonsatiated. This can be shown by satisfying the condition,

would show that for every one unit increase in wealth, satisfaction will increase as well. For this utility function, we will get:

U (W )  0 . This W

U (e W )  0  (e W )( )  0   e W  0 W
Because W > 0, we can then conclude that more is preferred to less consumption given the utility function. (1b) To prove that the consumer is risk averse we must show that this utility function has diminishing marginal utility wherein the condition

that the marginal utility from an extra increase of utility decreases as your payoff increases. Hence, this would represent risk-aversion since the bigger the amount of money that is at stake, the higher satisfaction from winning is offset by an even higher dissatisfaction from losing. For this utility function we get:

U 2 (e W )  0 must be satisfied. This means  2W

U 2 (e W ) U 2 (e W )  ( e W )( )   2e W  0 0  2 2 W W
Since the second order derivative of the function gives a negative value, we could say that the consumer is risk averse. (2a) There are two measures of risk aversion that was developed by Pratt and Arrow. The first measurement would be the absolute risk aversion coefficient/index. This measurement helps show how much wealth an individual is willing to expose to risk as a function of changes in wealth. In order to solve for this, we used the formula that was defined by Pratt and Arrow, A(W )   . For this utility function we get:

U "(W ) U '(W )

A(W )  

(2b) The second measurement of risk aversion is the relative risk aversion coefficient/index. This also helps measure how much wealth an individual is willing to expose to risk however in

 2e W Simplifying the equation, we get: A(W )    e  W

percentage form. Hence, it then helps us measure the percentage of an individual’s wealth he/she is willing to expose to risk. As defined, R(W )  

U "(W )  W . For this utility function, we get: U '(W )

R(W )  

 2e W  W  R(W )  W  e W

(3a) We could measure the effect of  on the absolute risk aversion by getting the partial derivative of A(W) with respect to  :

dA(W ) 1 d
This shows that for every unit increase in α, A(W) increases by 1. Hence, the greater the parameter, the more risk-averse this individual is. (3b) We could measure the effect of  on the relative risk aversion by getting the partial derivative of R(W) with respect to  :

This shows that for every unit increase in α, R(W) increases by the value of wealth. This then means that this individual’s risk aversion is dependent on the amount of wealth he/she has. (4a) To get the effect of the changes in W with the behavior of the degree of absolute risk aversion, we must get the partial derivative of A(W) with respect to W:

dR(W ) W d

dA(W ) 0 dW
This means that the individual has CARA or constant absolute risk aversion. That is, if his/her wealth increases, he/she will not change the amount of pesos invested in a risky assest. (4b) To get the effect of the changes in W with the behavior of the degree of relative risk aversion, we must get the partial derivative of R(W) with respect to W:

dR(W )  dW
This means that the individual has IRRA or increasesing relative risk aversion. That is, if his/her wealth increases, the percentage of his/her wealth invested in a risky asset decreases. Hence, the more wealth an individual receives, the larger the percentage of his wealth he would wish to keep safe.

II. Given:

U (W ) 

W

 1 G (50000;10000;0.5)
G 2 ( x;0;1)

where W>0 and α is a parameter

In order to determine the value of x, we must first show that the individual is indifferent to both gambles. In order for an individual to indifferent, the two gambles must give the same amount of satisfaction or expected utility according to the Expected Utility Theorem that states that an individual decides between gambles as if he/she were to maximize utility. Therefore, indifference ( ) would mean ( ) where represents a gamble with risk while represents a ( ) gamble which is sure. This can also be written as ( ). ( ) ∑ Because ( ) since a gamble has a random outcome and we assume then that it will occur on average we can then solve for it as: ( ) ( ( ( We end up with this equation: ( Then by substituting α with 0.25: ( Simplify, and you will get ) =( ( ) ( ) ) ( ) ( ) )) ( ) )( ( ( )) )

) and by transposition, we will come up with

By checking we will get:

0.5  (

49.91=49.91

500000.25 100000.25 24232.880.25 )  0.5  ( )( ) 0 0.25 0.25 0.25

By substituting α with 0.75: ( Simplify, and you will get ) =( ( ) ( )

) and by transposition, we will come up with

By checking we will get:

0.5  (

2,895.80=2,895.80

500000.75 100000.75 24232.880.75 )  0.5  ( )( ) 0 0.75 0.75 0.75

Since both sides of the equation are equal, we could say that the consumer is indifferent between the risky gamble G1 and the sure gamble of G 2 when the sure pay off of G 2 is equal to P24,232.88 when α = 0.25 and P 28,125.91 when α = 0.75. These values represent the amount of certain money the individual would receive in a sure gamble but has the same expected utility as if the individual would have entered into the risky gamble. This is also known as certainty equivalent of this individual’s wealth with the risky gamble. Although it may be less than what one can possibly get, this individual shows that he/she would be equally as pleased to have this certain wealth as the risky wealth. Being a risk-averse individual like most people, this certain equivalent would be preferred rather than the risky wealth. The parameter also has a lot to do with the risk aversion of this individual. As you can see, when the parameter increased, the certain equivalent of the risk gamble increased as well. This means that the higher the parameter, the less risk-averse the individual since he/she associates the same amount of risky wealth to higher certain wealth. Hence, if we were to place this in a scenario where the individual could get insured for this risky gamble, he would have to pay a smaller amount of insurance premium as compared to the individual with a parameter of 0.25. In relation, the more risk-averse you are, the more you demand to pay a higher premium to enter into a risky gamble. III. Given: W0 = ₱ 100,000

U (W )  ln W for W  0

As defined, W = W0 + Zs, hence to solve for the pay offs we just simply transpose. You can see in the table below what pay off each state of the world has. State, s 1 2 3 Worth (₱) W, Ws 1 50,000 100,000 Probability, Ps 0.02 0.04 0.94 Zs = W0 - Ws -99,999 -50,000 0

In order to find out the maximum amount he will pay for an insurance policy that pays in full any loss that he incurs, we must first fulfill the condition that EU(W)Insurance= EU(W)w/o insurance . It is at this point where you are as well off as you would be if forced to face the world without insurance. We must take note however that the expected utility of wealth with insurance is certain as you are covered even with a loss, which allows us to express it as: EU(W)Insurance = U(W0 - π) We subtract the premium, π, from our original wealth since you have to pay this in order to avail of the insurance. Through substitution, we will get: U(W0 - π) = ln(100,000 – π)

As defined previously, to solve for expected utility (which is a random outcome), we will assume that it will occur on average. This means we can calculate it by: EU(W)w/o Insurance = 0.2 (ln 1) + 0.04 (ln 50000) + 0.94 (ln 100,000) Hence, EU(W)Insurance= EU(W)w/o insurance through substitution would be: 0.2 (ln 1) + 0.04 (ln 50,000) + 0.94 (ln 100,000) = ln (100,000-π) 11.25494107= ln (100,000-π) ℮ 11. 25494107 = ℮ ln (100,000-π) Solving for the premium by transposition, we will get: π = 22,739.31279 The maximum amount that he is willing to pay for the insurance policy would be P 22,739.31. This would be mean that anything above this amount, the individual will not avail of the insurance policy anymore. IV. Given: Perfect capital markets: U (W) = W0.5 G1 = (36; 16; 0.5) in ₱ W0 = 0 When there are perfect capital markets, this means that transactions in the capital market (may it to borrow or to lend) can be made without payment of charges other than the prevailing market rate of interest since no agent is large enough to affect prices or interest rates. Also, there is symmetric information among market participants. This means that the individual is open to either borrowing or spending money throughout his decision of joining into the gamble or not. However, we will first assume that this person starts out with zero wealth hence, we can solve for the certainty equivalent of the gamble and maximum premium he is willing to pay. (1) The certainty equivalent, CE(W0,z) of the gamble is the peso amount of certain payoff at which the investor would be indifferent to the risky investment and this certain amount. By definition, EU(W0 + Z) = U(W0 + CE(W0,z)) = U(W0 + E[Z] – ∏) As defined previously, to solve for expected utility (which is a random outcome), we will assume that it will occur on average. This means we can calculate it by:

EU  W0  z   0.5  360.5  0.5  160.5 EU  W0  z   5

5  (CE(0,0.5))0.5 By raising both sides to 1 , we can solve for CE(0,0.5) : 0.5 CE(0,0.5) = 25 and Wc = W0 + CE = 25

This means that the individual is indifferent to receiving a sure pay off of P25.00 as compared to the risky pay off of receiving either P36.00 or P16.00. The P25.00 also represents this individual’s Wc or the amount of certain wealth that the individual is indifferent to when compared to receiving the risky wealth of either P36.00 or P16.00 since our starting wealth is 0. (2) The risk premium of an individual is the amount that the person is willing to pay in order to assure/insure a certain amount from his/her risky gamble. Hence, may the gamble go good or bad, the individual will still receive this certain amount which was solved earlier, CE. By definition: CE (W0, z) = E[z] - ∏ (W0, z) where ∏ is the premium In order to solve for the premium, we must solve for E[Z] first. To get this expected value of the pay offs 36 and 16, like explained many times earlier, we will assume that it occurs on average hence, the E[Z] would be equal to the mean of these two values or (0.5)(36) + (0.5)(16) = 26 Now that we have both CE (W0, z) and E[Z], we can now solve for ∏ (W0, z) by substitution: CE (W0, z) = E[z] - ∏ (W0, z) 25 = 26 - ∏ ∏ = 26 - 25 ∏=1 Hence, the consumer is willing to pay a maximum of P1.00 in order to insure an amount of P25.00 from the gamble. However we must consider the fact the individual has an initial wealth of 0. Hence, if ever he/she wishes to pay for this amount to acquire the insurance, he would have to borrow from the capital market. (3) Usually we try to prove that the individual will be willing to pay the premium because he/she is risk averse. In order for this to be proven we have to satisfy the condition that [ ]) ( )] [ ( provided that the investor is risk averse. This would also then imply that the investor will only be willing to pay for an uncertain payoff that would have to be priced less than its expected payoff, E[Z]. First, let’s prove the individual is risk averse through the second ordered derivative of his utility function in respect to W or U’’. This is because U’’ shows the shape of his utility function. As explained previously, if U’’ is negative that would mean that the shape of his/her utility function is strictly concave which means he is risk-averse. For this individual his U’’ is equal to: ( ) Hence, this individual is risk-averse.

Now, to solve for the probability premium, or the minimum increase in the probability of the high payoff state so that the individual will not be willing to pay any premium, we will have to then satisfy the condition that [ ]) ( )] [ ( because it is at this point where the individual will then be indifferent between the two utilities. Therefore, the individual will no longer be willing to avail of the premium at this point since there his/her risky payoff is priced just as much as his expected payoff. Therefore, to solve for the increase change in the higher payoff probability (denoted as p) we will add p to the probability of 36. Because there must be a balance between the two probabilities (since for an event to surely happen you only need a probability of 1 and nothing more than that), we must then subtract p from the probability of the lower payoff. This is illustrated in the solution below, after substitution: ( And when simplified, we get: Solving for p by transposition, we will arrive with: p = 0.0495097568 or 0.050 This would then mean that once the probability of 36 has increased by 0.050 or has reached 0.55, then the individual will no longer avail of the premium, as explained earlier. V. Given: )( ) ( )( )

5 2 W 0.2 W  10000 U (W )  
S 1 2 3 4 5 Ls (₱) 1000 2000 3000 5000 6000 Ps 0.10 0.20 0.35 0.20 0.15 Ws = W0 + Ls 10000 – 1000 = 9000 10000 – 2000 = 8000 10000 – 3000 = 7000 10000 – 5000 = 5000 10000 – 6000 = 4000

(1) The certainty equivalent of the risky gamble CE(W0,Z), as explained earlier, is the peso amount of certain payoff at which the investor would be indifferent to the risky investment and this certain amount. We must first solve for this before attaining the certainty equivalent of the risky wealth you can are willing to pay your risk premium for. By definition, ( ) ( ( ( ) ) ) ( [ ] ( ( )) ( )) ))

So that, ( )

(

[ ]

Where is the random payoff or the loss in this problem. Substituting the given values to our equations given we will arrive with:

( ( ( ( ( ( ) )

) ) ) ) (
(

( (

) )

(

)

(

)

1.130650242 (
( ))

))

By equating

(
(

)

(
( ))

) , we will get:

By solving for ( )

(

) through transposition method, we will arrive with:

This means that this is the amount that you are willing to pay a premium for to assure such a loss. Take note that the certainty equivalent for this situation is negative because in this situation, all payoffs are losses. This means that no matter what may happen, the individual will incur a loss and –P3,706.72 is the amount that the individual will be indifferent with the expected risky loss that he might incur . Hence, this individual’s Wc or his certainty equivalent of his risky wealth would be equal to: ( )  Wc = 10,000 + (-3,706.72)  Wc =P 6,293.28 W c = W0 + This is then the amount that the investor will be willing to pay for to avoid the risk of receiving anything less. So, if the insurance policy is availed of, then the individual is assured P6,293.28 no matter what may happen. (2) Similarly as part V of this assignment, we will solve for risk premium. As explained previously, the risk premium of an individual is the amount that the person is willing to pay in order to assure/insure a certain amount from his/her risky gamble. Hence, may the gamble go good or bad, the individual will still receive this certain amount which was solved earlier, CE. [ ] ( ) From (1) we have stated that ( )) . Hence, by transposing ( ) to the left side of the equation we could solve for the risk premium. So that: ( Where: ) [ ] ( )

[ ] ( )

(

(

)

)

(

)

(

)

By simplifying we will get: [ ] which was solved through the different rules of expectations for a random variable where we assume that it occurs “on average.” Hence, [ ] is the weighted mean of the losses given in the table which explains the sign of the value we came across with. Given the values, we could solve for the premium by substituting the values to the given formula: ( ( ( ) ) ) [ ] ( ( ) ) to avoid the risk in gambling that will allow him

The consumer is willing to pay to attain a sure wealth of P 6,293.28.

Similar Documents

Premium Essay

Going Concern

...Going Concern Group 4 ACCT 632, Advanced Financial Acct Theory Liberty University Aug 7, 2013 GOING CONCERN Summary of Going Concern current exposure draft Comparison and Contrast of current Going Concern theory and standards 1 Guidance provided by AU Section 341 2 Guidance provided by 17 U.S.C. §229.303 3 Proposed guidance of exposure draft Comparison and Contrast of U. S. GAAP and IFRS with respect to Going Concern 1 Current Going Concern variations between U. S. GAAP and IFRS 2 Variations between proposed changes to Going Concern issues The Benefits and Costs of a Going Concern Amendment 1 Providing preparer guidance 2 Making management responsible 3 Addressing investor concerns Provisions in light of the FASB’s Conceptual Framework 1 Understandability 2 Decision usefulness 3 Relevance 4 Comparability Response to Going Concern Exposure Draft 1 Proposed changes or corrections to the current exposure draft References Going Concern People go into business for many reasons, but no one goes into business with the expectation that they are not going to be successful. For that reason, acquisition is made for those assets that are needed to run the company with the understanding that there will be no need to arrange for early liquidation. Because there is no prediction to inform someone that their business may or may not make it, managers must rely...

Words: 4936 - Pages: 20

Premium Essay

Faithful Representation

...A critical review of the trade-offs between the concepts of relevance and reliability in financial reporting Theme: Financial Accounting Classification: M41 Author: Prof D Coetsee Affiliation: Department of Accountancy, University of Johannesburg, South Africa Contact address: Department of Accountancy R-Ring 607 University of Johannesburg PO Box 524 Auckland Park Johannesburg South-Africa 2006 Telephone: +27-11-559-3047 Fax: +27-11-559-2777 E-Mail dcoetsee@uj.ac.za A critical review of the trade-offs between the concepts of relevance and reliability in financial reporting |Abstract | |In an information orientated system of financial reporting the move from historical cost to fair value | |accounting has created numerous debates surrounding the trade-offs of the concepts of relevance and | |reliability. This article contributes to the debate by critically reviewing the current developments of | |these trade-offs to determine whether current financial reporting guidelines are appropriate to deal with | |the difficulties and uncertainties of financial reporting. The article found that the proposals of the joint| |framework discussion paper goes a long way in resolving the issues around the trade-offs of relevance and | |reliability. Changing the concept of reliability to faithful representation...

Words: 6702 - Pages: 27

Premium Essay

Internet Finance

...Chapter 2 A Behavioral Finance Approach to Decision Making in Entrepreneurial Finance Rassoul Yazdipour By ‘uncertain’ knowledge, let me explain,… We simply do not know. J.M. Keynes (1937) Humans have an additional capability that allows them to alter their environment as well as respond to it. This capacity both creates and reduces risk. Paul Slovic (1987) All risk that is acted upon must be perceived risk because perception is based upon sensory data. We can only sense the ‘real world’ because we have no other way of being informed. Robert Olsen (2010) Understanding a problem is half of the solution Unknown Abstract  Three central decisions in entrepreneurship and entrepreneurial finance – entry/seed funding, financing/investment, and growth/exit – are discussed and case is made for applying the behavioral finance theories and concepts to better understand the involved decision processes, and consequently, to help improve the decisionmaking process for both entrepreneurs and venture capitalists. The behavioral finance approach is important because the traditional finance has remained silent on the first issue, and the Agency Theory (financial contracting), which is effectively the only theory that is applicable to issues in entrepreneurial finance, has produced mixed empirical results. (See for example Bitler et al. [Bitler MP, Moskowitz T J, VissingJorgensen A (2009) Why do entrepreneurs hold large ownership shares? Testing agency theory using entrepreneur...

Words: 7844 - Pages: 32

Free Essay

The Real Option Theory

...Managerial Finance | Use of Real Options Theory in Financial Management/Modeling | Tiffany Allen | BUS 650 | Prof. Achilles | 11/14/2011 | | Abstract In business, as in life, you always have options to choose from. In today's extremely unstable market, managers realize how incredibly risky some investment opportunities can be, and how useful a flexible strategy can be. Using real options theory, managers can more effectively analyze opportunities to pursue, delay, modify, or abandon projects as events unfold. This paper analyzes the use of real option theory in financial   management and modeling. It discusses issues included in the implementation of the theory in financial management and modeling. It explains new  learning  in  real  option  theory  and a case study that was able to apply the theory along with the application of the theory to my current business which has  helped me understand real option theory. Use of Real Options Theory in Financial Management/Modeling The Real Option Theory has struck some interest with managers in the last couple of decades. Back in the day, companies had plenty of time to make decisions to make changes when they felt it was necessary. Now, if they take their time deciding on changes, chances are by the time they finally make a decision, another company has already made the move. Times have change and especially with how the economy is today, it’s a “Dog Eat Dog World” and in this competitive market, you...

Words: 2959 - Pages: 12

Premium Essay

Financial Statements

...This paper is all about financial statements. An introduction to financial statements is presented to give a background to the reader. In the introductory part, the fundamental accounting concepts used in the preparation of financial statements are included together with the explanation of their basis. Examples are also given as an illustration of its application. This consist the first part. On the other hand, the second part is about the evaluation of the role of financial accounting in aiding the decision-making processes of the four different non-management stakeholder groups. An explanation of the nature of these decisions is also included. The paper ends with the issue on the conflicts arising from the diverse interest of the said entities to the financial statements. Introduction to Financial Statements One of the steps included in the accounting cycle is the preparation of the principal financial statements. They are the Income Statement and the Balance Sheet. These financial statements are a means by which the information accumulated and processed in financial accounting is periodically communicated to the users. Once the worksheet is completed, it is easy to prepare the financial statements as the necessary data have already been summarized. A third financial statement, which is the Statement of Cash Flows, provides information about cash receipts and cash payments into operating, investing, and financing activities. A Balance...

Words: 2321 - Pages: 10

Premium Essay

Decision Analysis Theory

...public groups based on a number of assumptions. Typically actions that are deemed in the public interest generally occur when governments seek to intervene in situations where market failure occurs. Market failure may arise due to monopolies, barriers to entry for new businesses, and information gaps. Public interest theory makes three assumptions. First, interest of consumers is translated into legislative action through operation of the internal marketplace. Secondly, agents will seek regulation on behalf of public interest. The third assumption being that government has no independent role to play in the development of regulation. In 2002 the Sarbanes-Oxley Act was created in America to enforce greater regulation and compliance for financial reporting and corporate governance. This Act was created in response to corporate scandals involving larger companies like Enron and Tyco International, and thus public interest theory suggests the government’s response was as a result of market failure due to inaccurate auditing and accounting procedures. The premise of private interest theory is that governmental bodies and political leaders use their power to coerce businesses through taxation, regulation, and subsidies. The Basic assertion of privation interest theory is the law of diminishing returns which exists between group size, and costs of using political process. A second assumption is government officials are rationally self-interested. Politicians seek re-election therefore...

Words: 1740 - Pages: 7

Free Essay

Finance Behavioural

...Behavioural Finance Martin Sewell University of Cambridge February 2007 (revised April 2010) Abstract An introduction to behavioural finance, including a review of the major works and a summary of important heuristics. 1 Introduction Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient. For more information on behavioural finance, see Sewell (2001). 2 History Back in 1896, Gustave le Bon wrote The Crowd: A Study of the Popular Mind, one of the greatest and most influential books of social psychology ever written (le Bon 1896). Selden (1912) wrote Psychology of the Stock Market. He based the book ‘upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public’. In 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance (Festinger, Riecken and Schachter 1956). When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs. Pratt (1964) considers utility functions, risk aversion and also risks considered as a proportion of total assets...

Words: 4442 - Pages: 18

Premium Essay

Marketing Mix

...money. At the micro level, finance is the study of financial planning, asset management and fund raising for business and financial institutions. At the macro level, finance is the study of financial institution and financial markets and how they operate within the financial systems in both the domestic and global economics. Scholar’s view: “Finance consists of providing and utilizing the money, capital rights, credit and funds of any kind which are employed in the operation of an enterprise.” _George R Terry “Finance is concerned with the process, institutionsmarkets and instruments involved in the transfer of money among and between individuals, business and governments”. _Lawrence J Gitman From the above discussion, it can be said that finance is the process of financial planning, identification of sources of fund raising, investment of fund, protection of fund, distribution of profit to achieve the goal of the organization. Question-2: What is business finance? Ans: Generally, finance which is concerned to meet all the financial needs of business enterprise is called business finance. Alternatively; business finance is the field of study with the help of which one can understand formulation of financial planning, organizing and controlling...

Words: 7921 - Pages: 32

Free Essay

Behavior of Finance

...Behavioural Finance Martin Sewell University of Cambridge February 2007 (revised April 2010) Abstract An introduction to behavioural finance, including a review of the major works and a summary of important heuristics. 1 Introduction Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient. For more information on behavioural finance, see Sewell (2001). 2 History Back in 1896, Gustave le Bon wrote The Crowd: A Study of the Popular Mind, one of the greatest and most influential books of social psychology ever written (le Bon 1896). Selden (1912) wrote Psychology of the Stock Market. He based the book ‘upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public’. In 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance (Festinger, Riecken and Schachter 1956). When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs. Pratt (1964) considers utility functions, risk aversion and also risks considered as a proportion of total assets. Tversky and Kahneman...

Words: 4442 - Pages: 18

Premium Essay

Modigliani and Miller

...the effect of financial structure of the firm on market valuations. In other words, does capital structure influence value of the firm? I believe the introduction of the paper gives an important explanation of how Modigliani has reached his theorem, because his main goal was to correct the drawbacks of other theories. To understand the importance of such a theory, I considered adding these other theories as an introduction of this summary. The cost of capital to the owners of a firm is simply the rate of interest in bonds; this has derived the proposition that the firm, acting rationally, will tend to push investment to the point where the marginal yield on physical assets is equal to the market rate of interest. This proposition follows from either of two criteria of rational decision-making: (1) the maximization of profits, and (2) the maximization of market value. Under either formulation, the cost of capital is equal to the rate of interest on bonds. These have equivalent implications under certainty (Certainty Equivalent Approach) but not under uncertainty. The attempt of allowing uncertainty takes the form of superimposing on the results of the certainty analysis the notion of a risk discount to be subtracted from the expected yield. No satisfactory explanation has yet been provided as to what determines the size of the risk discount and how it varies in response to changes in other variables. The profit maximization criterion, under the world of uncertainty, is no longer...

Words: 921 - Pages: 4

Premium Essay

Management

...Significance and Limitations of Rational Decision-making Managers as Decision-makers The Rational Model Non-rational Models Decision-making Process Types of Managerial Decisions Programmed Decisions Non-programmed Decisions Decision-making Under Certainty, Uncertainty and Risk Management Information System vs Decision Support System The Systems Approach to Decision-making Group Decision-making Forms of Group Decision-making Decision-making Techniques Summary Decision-making describes the process by which a course of action is selected to deal with a specific problem. The success of an organization depends greatly on the decisions of managers. There are two major types of models used by managers to make decisions - (1) rational model and (2) non-rational models. In the rational model, managers engage in rational decision-making processes. At the time of decision-making, they possess as well as understand all the information that is relevant to their decision. In contrast, non-rational models of managerial decision-making suggest that limitations of information-gathering and information-processing make it difficult for managers to make optimal decisions. The three non-rational models of decision-making discussed in the chapter are: satisficing, incremental, and garbage-can models. Any decision-making process contains seven basic steps: (1) identifying the problem; (2) identifying resources and constraints, (3) generating alternative...

Words: 555 - Pages: 3

Premium Essay

Circular Flow Chart

...Description Managerial Economics is concerned with resources allocation, decisions that are made by managers in both private and public sections (private business, private NGO’s and public sector) of the economy. The course emphasizes the application of economic principles and methodologies to decision-making process of business firms operating under conditions of risk and uncertainty. Managerial Economics, thus, uses concepts, models and analytical techniques of economics to study and analyse the operations of businesses and the type of problems managers face. Hence it provides important conceptual insights for gaining a better understanding of business environment and for making of quality business decisions with minimal trial and errors. 2. Objectives: 2.1 To provide participants with a much clearer view of the applicability and relevance of economics to decision making within business firms. 2.2 To develop students’ knowledge of applied economics 2.3 To develop students’ analytical skills to a higher level. 2.4 To enhance students’ insight into the operation of business and the nature of problems managers face. 3. Course coverage * Introduction of students to Managerial Economics and the use of models and other analytical concepts in decision making process. * Introduction to the concept of risk and uncertainty and adjustment of decisions to reflect decision maker’s attitude towards risk. * Behaviour of consumers and...

Words: 2791 - Pages: 12

Premium Essay

Ouchiframework

...2. A Theoretical Research Framework This chapter presents a brief overview of the most relevant theoretical concepts of management control, accounting information systems, performance budgets and the roles of budgets. These general accounting concepts, applicable in both the private and public sector, are used to compose a research framework for analyzing the role of budgeted performance measures in Dutch local government. Organizational and management control Control, next to strategy formulation and objective setting, is one of the critical management processes (Merchant, 1998; Merchant and Van der Stede, 2003). The term “organizational control” has no single generally accepted definition. Literature presents various definitions, describing organizational control as a process (of setting a standard, observing what is happening, comparison of observation and standard, and if necessary, behavior altering communication), or by its main goal (e.g. assuring implementation of strategies). Anthony (1988) has provided a general accepted structure for organizational control. His traditional framework distinguishes three separate and distinct processes; being strategy formulation, management control, and task control. Within this concept, task control and strategy formulation form the boundaries of the management control process. Strategy formulation is the process of deciding on the goals of the organization and the strategies for attaining these goals. Task control is the process...

Words: 9218 - Pages: 37

Premium Essay

Asdasd

...RMIT International University Vietnam Bachelor of Business (Accountancy) Assignment Cover Page | Subject Code: |ACCT2163 | | | | |Subject Name: |Accounting Theory | | | | |Location & Campus (SGS or HN) where you study: |RMIT Vietnam | |Title of Assignment: |Individual assignment | | | | |Student name: |Pham Thanh Huong | |Student Number: |S3275153 | | | | |Teachers Name: ...

Words: 2888 - Pages: 12

Premium Essay

Life's Choices Case Analysis Week #5

...Life's Choices Case Analysis Week #5 Uncertainties and Decision Uncertainty becomes relevant to a decision problem when it is impossible to know which outcome will occur. This may be due to missing information, or because the outcome depends on other factors. Mark and Annie must have a method of dealing with uncertainty in their decision determine the expected value of potential outcomes. A decision tree is a method of assessing the preferred outcome where multiple sources of uncertainty may exist. As an analysis model that provides a graphical alter¬native to a decision by illustrating conditions and actions in sequence a decision tree can help Mark and Annie with their uncertainties. By looking at the decision to be made, chance or uncertain events and scenario, scenario outcomes, and probability outcomes, Mark and Annie may have an easier time making their choice. Trade-off becomes relevant whenever a decision problem involves multiple, possibly conflicting, objectives. In Mark and Annie's situation more than one objective is relevant. In some cases, an option may also be dominated if it only offers very small advantages but has significant disadvantages. By ranking objectives on a scale, one method of converting rankings to a similar scale is proportional scoring. Using this method, the best outcome is assigned a rating of 100, the worst a rating of 0, and all other outcomes are given a rating based on where they fall between those two scores. If the outcomes...

Words: 731 - Pages: 3