Question

How does a business manager use probabilities for investment analysis?

Answer 1

Say a business manager is planning to accept or reject a project. The Cost of Capital for the project is 12%, so if the expected return from the project is more than 12%, then only he will accept the project.

There are three expected return from the project with different probabilities of occurrence.

Return 18% --- Probability 30%

Return 12% ----- Probability 30%

Return 5% ----- Probability 40%

Actual Expected Return = Summation of (Return) * (Probability)

= { (18%) * (30%) + (12%) * (30%) + (5%) * (40%)}

= 11%

As the Actual expected return is below cost of capital, so the project will not be accepted.

This is how manager makes decision, whether to invest in a project or not.