Slides 3 1 calculate expected values of alternative courses

What is Expected Value?• Recognizes that cash flows are frequently tied to uncertain outcomes • Example: It is difficult to plan for cost when different performance scenarios are possibl

Calculate Expected Values of

Alternative Courses of Action

Ever had a vacation disaster?

Car trouble? Lost luggage?Missed flight? Something worse?How did that affect

your vacation

cash flows?

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Terminal Learning Objective

• Task: Calculate Expected Values of Alternative Courses

of Action

• Condition: You are training to become an ACE with

access to ICAM course handouts, readings, and

spreadsheet tools and awareness of Operational

Environment (OE)/Contemporary Operational

Environment (COE) variables and actors

• Standard: With at least 80% accuracy:

What is Expected Value?

• Recognizes that cash flows are frequently tied

to uncertain outcomes

• Example: It is difficult to plan for cost when

different performance scenarios are possible and the cost of each is vastly different

• Expected Value represents a weighted average cash flow of the possible outcomes

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Applications for Expected Value

• Deciding what cash flows to use in a Net

Present Value calculation when actual cash

flows are uncertain

• Reducing multiple uncertain cash flow

outcomes to a single dollar value for a “reality check”

Expected Value Calculation

• Expected Value =

Probability of Outcome 1 * Dollar Value of Outcome 1

+ Probability of Outcome 2 * Dollar Value of Outcome 2

+ Probability of Outcome 3 * Dollar Value of Outcome 3

etc.

• Assumes probabilities and dollar value of

outcomes are known or can be estimated

• Probability of all outcomes must equal 100%

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Expected Value Example

• The local youth center is running the following

fundraising promotion:

• Donors will roll a pair of dice, with the following outcomes:

• A roll of 2 (snake-eyes): The donor pays $100

• A roll of 12: The donor wins $100

• 3 and 11: The donor pays $50

Expected Value Example

• What are the possible outcomes?

• 2, 12, 3, 11 and everything else

• What are the cash flows associated with each outcome?

3 and 11 -50 All else -25

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Expected Value Example

• What are the probabilities of each outcome?

3 and 11 4/36 All else 30/36

Expected Value Example

• Calculate Expected Value:

• Given this expected value, will you roll the

Expected Value Example

• Calculate Expected Value:

Outcome Probability * Cash Flow = Expected Value

3 and 11 4/36 * -50 =

All else 30/36 * -25 =

Expected Value Example

• Calculate Expected Value:

• Given this expected value, will you roll the

Expected Value Example

• Calculate Expected Value:

Outcome Probability * Cash Flow = Expected Value

All else 30/36 * -25 =

Expected Value Example

• Calculate Expected Value:

• Given this expected value, will you roll the

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Expected Value Example

• Calculate Expected Value:

Outcome Probability * Cash Flow = Expected Value

All else 30/36 * -25 = -20.83

Expected Value Example

• Calculate Expected Value:

• Given this expected value, will you roll the

Learning Check

• What variables must be defined before

calculating Expected Value?

• What does Expected Value represent?

• Behind each of the other two curtains there is a $100 bill

• Task: Calculate the Expected Value of Sheila’s

alternative courses of action

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Demonstration Problem

• Step 1: Define the outcomes

• Step 2: Define the probabilities of each

Define the Outcomes

Define the Probabilities

Keep the $1,000

• Sheila already has the

$1,000 in hand

• This is a certain event

• The probability of a certain

Define the Probabilities

Keep the $1,000

• Sheila already has the

$1,000 in hand

• This is a certain event

• The probability of a certain

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Define the Cash Flows

Keep the $1,000

• Cash flow is $1,000

Trade $1,000 for Curtain

Outcome Cash Flow

Car

$100

Define the Cash Flows

Define the Cash Flows

Keep the $1,000

• Cash flow is $1,000

Trade $1,000 for Curtain

Define the Cash Flows

Calculate Expected Value

Learning Check

• How can Expected Value be used in comparing alternative Courses of Action?

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Expected Value Application

• Your organization has submitted a proposal for a project Probability of acceptance is 60%

• If proposal is accepted you face two scenarios

which are equally likely:

• Scenario A: net increase in cash flows of $75,000

• Scenario B: net increase in cash flows of $10,000

• If proposal is not accepted you will experience no

Expected Value Application

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Expected Value Application

Expected Value Application

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Expected Value Application

Expected Value and Planning

• If you outsource the repair function, total cost will equal $750 per repair

• Historical data suggests the following

Expected Value and Planning

• Expected Value of outsourcing:

100 repairs 25% * 100 * $750 = $75,000 = $18,750

300 repairs 60% * 300 * $750 = $225,000 = $135,000

500 repairs 15% * 500 * $750 = $375,000 = $56,250

Expected Value and Planning

• If you insource the repair function, total cost will equal $65,000 fixed costs plus variable

cost of $300 per repair

• How much should you plan to spend for repair cost if you insource?

• Given these assumptions, which option is

more attractive?

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Expected Value and Planning

• Expected Value of insourcing:

100 repairs 25% * (100 * $300) + $65,000 = $95,000 = $23,750

300 repairs 60% * (300 * $300) + $65,000 = $155,000 = $93,000

500 repairs 15% * (500 * $300) + $65,000 = $225,000 = $33,750

Expected Value and NPV

• Proposed project requires a $600,000 up-front investment

• Project has a five year life with the following

potential annual cash flows:

• 10% probability of $300,000 = $30,000

• 70% probability of $200,000 = $140,000

• 20% Probability of $100,000 = $20,000

• What is the EV of the annual cash flow? $190,000

• How would this information be used to evaluate the project’s NPV?

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Expected Value and NPV

• Proposed project requires a $600,000 up-front investment

• Project has a five year life with the following

potential annual cash flows:

• 10% probability of $300,000 = $30,000

• 70% probability of $200,000 = $140,000

Practical Exercises

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Expected Value Spreadsheet

Use to calculate single scenario expected values

Expected Value Spreadsheet

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Spreadsheet tool permits comparison of up to four courses of action Uses color coding to rank

options

Practical Exercise