ITC4780 Unit V Mini Project

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Probability (P) times Outcome = EMV

P=.20 *

< P=.80 $300,000 = +$60,000

-$40,000 = -$32,000

-$50,000 = -$10,000

-$ 20,000 = - $2,000

$60, 000 = $42,000 ~

*

Project 2 *

P= .70

Project 1 's EMV = $60,000- $32, 000 = $28, 000 Proj ect 2's EMV = -$10,000- $2,000 + $42, 000 = $30,000

FIGURE 11-7 Expected monetary value (EMV) example

no reimburse ment if it is not awarded the contract. The sum of the probabilities for outcomes for each project must equal one (for Project 1, 20 percent plus 80 percent) . Probabilities are normally determined based on expert judgme nt. Cliff or other people in his firm should have some sense of their likelihood of winning certain projects.

Figure 11-7 also shows probabilities and outcomes for Project 2. Suppose there is a 20 percent probability that Cliffs firm will lose $ 50,000 on Project 2, a 10 percent probabili- ty that it will lose $20,000, and a 70 percent probability that it will earn $60,000. Again, experts would ne ed to estimate these dollar amounts and probabilities.

To calculate the expected monetary value (EJvfV) for each proj ect, multiply the proba- bility by the outcome value (or each potential outcome for each project and sum the results. To calculate expected monetary value for Project 1, going from left to right, multiply the probability by the outcome for each branch and sum the results. In this example, the EMV for Proj ect 1 is $28, 000.

.2($300 ,000) + .8( -$40 ,000) = $60,000- $32,000 = $28 ,000

The EMV for Project 2 is $30,000 .

.2 ( -$50 ,000 ) + .1(-$20 ,000) + .7($60,000) = -$1 0 ,000-$2 ,000 + .$42,000 = $30,000

Beca use the EMV provides an estimate for the total dollar value of a decision , you wa nt to have a pos itive number; the higher the EMV, the bette r. Since the EJvfV is positive for both Projects 1 and 2 , Clift"s firm would expec t a positive outcome from eac h and could bid 0n both proj ects. If it had to choose between the two proj ects , perhaps because of limited resources , Clift"s firm should bid on Project 2 because it has a higher EMV.

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Project Risk Management