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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.

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New Approach

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  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.

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