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The investment is spending money with expectations on return. Typically, the decisions with higher return expectations require certain risk, the options with moderate risk rate are characterized with medium risk, and the low-return decisions are the most reliable. Therefore, the investment decision is based on the investor’s expectation about the return, probabilities of success for different options, and willingness to take the risk (Dwivedi, 2010). Hence, a manager has to be aware of all the options and make the decision basing on reliable scientific tools. These tools are the decision tree and payoff analysis.
The decision analysis is meant to simplify and formalize the decision-making process. It is a tool for a manager, which helps him or her to think systematically. The decision tree provides a clear picture and helps to emphasize the important issues for the current situation. As a result, a manager makes more confident decisions (Nakatsu, 2009).
The first stage of decision-making process is development of the payoff table basing on the investments and probabilities. The problem is about choosing the investment option with the best payoff at different market conditions. The probabilities of success for each option are available, and they should be considered. NPV is net present value, or the expected financial return. The expected monetary value (EMV) is used to assess the potential loss of the decision:
The sample calculations for Real Estate development (in million):
EMV =($5.00 ∙ 0.5 + $2.00 ∙ 0.3 + $0.00 ∙ 0.2) - $0.75 = ($2.5 + $0.6 + $0.0) - $0.75 = $3.1 - $0.75 = $2.35
The calculation results are summarized in Table 1.
The payoff table for Excellent Consulting Group investment
The potential loss (PL) for each type of the decision is calculated as:
PL =Maximum (EMV) – Minimum (EMV) = $2.35 - $0.00 = $2.35.
However, this methodology requires calculations, and may by inappropriately implemented.
Figure 1 presents the decision tree for Excellent Consulting Group. The decision tree is performed in MS Excel, and EMVs are calculated automatically. The tree is solved according to the maximum profit principle, and thus Real Estate development option has been chosen. This strategy is also known as maximax decision, which takes the option with the maximal expected value (or potential profit) (Render, Stair, Hanna & Hale, 2016). The decision tree visualizes the decision-making process, and this is the significant advantage of this tool.
The decision-making theory also provides other ways for selection the strategy. Different investors might have different preferences about profit and loss, and therefore they have to understand the possible options. The decision tree presented maximax strategy, and there are three more: maximin, maximum likelihood criterion, and Bayes’ decision (Render, Stair, Hanna & Hale, 2016).
Maximin strategy is an option with the minimum loss. For the studied problem, the loss is minimal at Retail franchise for Just Hats project. At the low NPV, it provides profit of $1,000,000, and the investment is $500,000. Real Estate development would result in loss of investment at low NPV, and High Yield Municipal Bonds does not provide profit.
The maximum likelihood criterion chooses the decision among the options with the highest probabilities. For the studied case, the option Retail franchise for Just Hats should be chosen, as it is characterized with 0.75 probability and $3,000,000 profit. Another method named Bayes’ decision supposes choice of the project with the minimal potential loss, and Retail franchise for Just Hats is the option for this strategy.
The analysis of the investment options has indicated that the Real Estate development options should be chosen, if investors are interested in the maximum possible profit. The probability of the maximum profit is 0.5. From the other side, choosing Retail franchise for Just Hats guarantees high profit with 0.75 probability, and this option is also characterized with the minimal possible loss. It should be taken into the account that High Yield Municipal Bonds does not provide profit, and therefore it is not worth investing.
The decision-making process requires reliable and easy-to-use tools. Excel provides a comprehensive means for investment decisions. It performs all the calculations, and the manager’s role is about choosing the strategy: maximize profit, minimize loss, or choose the option with the highest probability of success. The tool performs all the calculations, and presents the numerical values, which are used to make decisions. However, the role of manager or investor should never be underestimated: the investment requires human decision, and simple figures generated by tools are not enough.
References
Dwivedi, D. N. (2010). Managerial economics. New Delhi: Vikas Publishing House Pvt. Ltd.
Nakatsu, R. T. (2009). Reasoning with Diagrams: Decision-Making and Problem-Solving with Diagrams. Hoboken: John Wiley & Sons.
Render, B., Stair, R. M., Hanna, M. E., & Hale, T. S. (2016). Quantitative analysis for management.
