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Uncertainty and the capital investment decision

University of British Columbia

A description of the events that preceeded an actual capital investment decision illustrates the importance of uncertainty in the decision process and provides a basis for developing criteria related to the needs of the decision maker in dealing with uncertainty. The sequence of events leading to the acceptance or rejection of a capital investment proposal is best characterized as a decision process in which uncertainty in the input information is reduced to a level consistent with the risk assuming preferences of the firm. The use of formal methods to relate economic benefits, uncertainty, and the risk assuming preferences of the firm within a single framework has been suggested and two methods, employing subjective probabilities as their distinguishing characteristic, are presented for analysis. The theory of subjective probability is found to gain acceptance only if specific assumptions are judged to be acceptable. A second set of assumptions also requires acceptance to justify utilization of the theory in any given practical situation. The analysis of the two methods, in relation to the criteria developed from the actual example, indicates that complete formalization cannot be attained in that no acceptable means of formally incorporating analysis of the risk assuming preferences of the firm is provided. The use of subjective probabilities serves only to formally combine economic benefits and uncertainty. Use of the resulting probability distributions must be based on an acceptance of the underlying assumptions of the theory and serve only as an aid to judgement. Any decision for the use of subjective probability distributions must rest with the individual decision maker.

Text

2011-06-27

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http://hdl.handle.net/2429/35766

Business Administration

University of British Columbia

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