Week 9

• A pound now is worth more than a pound in the future because you could invest it in the bank and get interest (also because of inflation and risk)
• The opportunity cost of making an investment (like buying a new production line) ie the rate of return that could have been earned by putting the same money into a different investment with the same risk
• CR means that there are not sufficient funds available to support all profitable projects
• •If CR exists, NPV will give misleading resultsprofitability index (PI): present value of cash flows divided by the present value of the investment cost

  •Need to establish the contribution per limiting factor

  •Limiting factor is cash (capital outlay)
• Calculate profitability index (PI): present value of cash flows divided by the present value of the investment cost
• •Rank projects in order from highest to lowest PI; accept projects in that sequence until capital available is used up
• Sometimes projects are divisible – ie if you can’t afford to invest in the whole thing, you can at least invest in part of it.
• If projects are not divisible then the ranking by Profitability Index may not work, as you may end up with some capital not invested at all.  In this case you have to work out the best combination of projects using trial and error.
• Long term decisions concern the future and depend on a number of variables
• Risk: Decision maker has sufficient information to determine the probability of each possible outcome
• Uncertainty: Decision maker can identify each possible outcome, but does not have the information necessary to determine the probabilities of each outcome
• The expected value is the average value you would get if what you’re doing is a trial that you could run over and over again. 
• EV

  1.Define scenarios, i.e. all possible outcomes

  2.Assign a probability to each scenario (note: the probabilities must add up to 1.0)

  3.Multiply each outcome by its respective probability

  4.Add all results

  5.The final number is the expected value
• The expected value is the average outcome if the situation is repeated many times, i.e. not useful for one-off events
• The probability of two independent events happening  is the probability of the first one happening multiplied by the probability of the second one happening.