Tuesday, May 17, 2022

Concept of Certainty, Risk and Uncertainty in Investment and Dynamic Environment

Everything changes in a dynamic environment. Nothing remains constant. Due to this, various risks & uncertainties need to consider in our engineering economic analysis.

In this post, various useful methods are discussed taking into account the probability of occurrence.

Certainty

Certainty is defined as a state of knowledge in which decision-maker
knows in advance the specific outcome to which each alternative will
invariably lead. i.e. decision-maker has perfect knowledge of the
environment and the result of whatever decision he might make i.e.

The high degree of confidence in all estimated quantities, revenues, and costs.
This degree of confidence is sometimes called

  • ASSUMED CERTAINTY or
  • DECISION UNDER CERTAINTY.

This is a rather misleading term, in that there is rarely a case in which estimated quantities can be assumed as
certain.

In all situations, there is doubt as to the ultimate results that
will be obtained from an investment.

The decision under Certainty → to those decision problems in which there
may have several possible outcomes whose probability of occurrence
can be almost perfectly (100%) known.

Risk

Risk is defined as a state of knowledge in which alternative leads to
one of a set of specific outcomes with each outcome occurring with a
the probability that is known objectively to the decision-maker.

Under conditions of risk, the decision-maker possesses some objective knowledge of the environment and is able to predict objectively the probability of the possible state of nature and outcome (or payoff) of each contemplated strategy.

The decision under Risk → to those decision problems in which there may
have several possible outcomes whose probability of occurrence can
be estimated.

Uncertainty

Uncertainty is defined as a state in which one or more alternatives
result in a set of possible outcomes where probabilities are either
unknown or not meaningful. Unlike risk, uncertainty is a subjective
phenomenon.

The decision under Uncertainty → decision problem is characterized by
several unknown future outcomes for which probabilities of
occurrence cannot be estimated.

Factors that affect uncertainty

The factors that affect uncertainty are many and varied. Four major
sources of uncertainty are:

  • Inaccuracy of estimates under the study: If exact information is available, the resulting accuracy of estimates should be good. If little information is available, the accuracy may be high or low, depending on the manner (or basis) in which estimated values are obtained.
  • Are they sound scientific estimates or merely wild guesses? If they are based on a considerable amount of past experiences or have been determined by an adequate market survey, a fair degree of reliance may be placed on them. If they are wild guesswork, it contains a sizable element of uncertainty.

Frequently, annual income and expenses contain more errors and are discovered to be the most sensitive elements in the study.

Most Sensitive elements of Expenses

Saving on operating expenses involves less uncertainty because based on considerable experience and past history.

  • Type of business (or projects or undertaking or ventures) involved in relation to the future health of the economy. Some lines of business such as mining are a notoriously less stable and high degree of risk than other businesses such as large retail food stores.

However, it cannot be said that investment in any retail food store always involves less
uncertainty than in mining. Uncertainty depends on the nature and history of business. No past history is usually rather uncertain.

  • Type of physical plant and equipment involved. General plants and equipment have definite economic lives and residual value whereas special type plants and equipment
    have little known economic lives and residual value.
  • Length of the assumed study period. A long study period naturally decreases the probability of all the factors turning out as estimated because the lengthier the study period, all else being equal, always increases the uncertainty in investment.

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