1 / 5

New Approach

New Approach. List alternatives For each alternative List possible scenarios and their probabilities Describe cashflow stream Calculate NPV Calculate E[NPV] Choose alternative with largest E[NPV]. alternative 1. alternative 2. alternative 3. scenario A. p a. p b. scenario B. p c.

toyah
Download Presentation

New Approach

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. New Approach • List alternatives • For each alternative • List possible scenarios and their probabilities • Describe cashflow stream • Calculate NPV • Calculate E[NPV] • Choose alternative with largest E[NPV]

  2. alternative 1 alternative 2 alternative 3 scenario A pa pb scenario B pc scenario C NPV= x Decision Trees • Decision nodes(we choose) • Chance nodes(stuff happens) • Outcome nodes

  3. Oil Well Example An oil field has a 50% probability of being rich, in which case it will produce cashflows of $5 million per year for 15 years, starting one year after an oil well is drilled. The field has a 50% probability of being poor, in which case it will produce cashflows of $1 million per year for 15 years, starting one year after an oil well is drilled. Drilling a well costs $15 million. The discount rate is 10%. What should you do?

  4. scenario A pa pb scenario B pc scenario C alternative 1 alternative 2 alternative 3 Solving Decision Trees • Calculate value V at each node • At outcome node: do NPV calculation • At chance node: take expectation of value of scenariosV(node) = pa V(a) + pb V(b) + pc V(c) • At decision node: • Pick value of largest alternativeV(node) = max { V(1), V(2), V(3) } • Prune sub-optimal branches (rejected alternatives)

  5. Old Problem An oil field has a 50% probability of being rich, in which case it will produce cashflows of $5 million per year for 15 years, starting one year after an oil well is drilled. The field has a 50% probability of being poor, in which case it will produce cashflows of $1 million per year for 15 years, starting one year after an oil well is drilled. Drilling a well costs $15 million. The discount rate is 10%. What should you do? Extension If you spend $1 million testing the oil field, then after 1 year you will learn whether the oil field is rich or poor, and you can decide then whether or not to drill. What should you do? Oil Example Cont.

More Related