1. Examples and Categories of Business Risks 1. Macro ( + Political ) econ growth, interest rates inflation, exchange rates 2. Micro (Demand & Cost) e.g. new product, risky R&D 3. Regulatory/Legal /Litigation political risks, expropriation 4. Competitive market-share battles, price wars, contractual Decision Making under UncertaintyChapter 12 slide 1 5. Natural Risks weather, natural disasters, Scientific risks 6. Human, Organizational reputation, corporate scandals Your job disappears in a reorganization

2. DRILLING FOR OIL Decisions Chance Events and Possible Outcomes.4.6 $600 -$200 Wet Dry Drill Don ’ t Drill Probabilities “ objective ” “ frequency-based ” “ subjective ” 120 $0 12.2

3. Investment Outcomes BioChem. $10 M $90 or $50 (.7) (.3) BioGen. $20 M $200 or $0 (.2) (.8) Drug Company R&D Decision 12.3 Expected  $68 M $20 M Which R&D program has the greater expected  ? What about Simultaneous Development? Simultaneous Development Only Biochem succeeds Only Biogen succeeds Both succeed Both “ fail ” Biochem BioGen BioChem $60 $170 BioGen BioChem $20 $170 $60 $20.14.06.56.24 72.4 170

4. Pursue BioChem Quit -$20 What about Sequential Development? Let ’ s try Biogenetic First then Biochemical. An R&D Decision (continued).2 $180.8 BioGen succeeds BioGen fails Try BioGen 48.7 $60.3 $20 BioChem succeeds BioChem “ fails ” 48 74.4 It ’ s best to resolve the “ larger ” risk first. 12.4

5. 5-Year Profits from a promising New Product depend on the strength of the Economy. Strong Economy: $20 M Moderate Economy: $10 M Recession: -$22 M Likelihoods of these outcomes? -22 Moderate Recession 10 20 Strong.36.40.24 LAUNCHING A NEW PRODUCT12.5 Decision Tree? Expected Profit? 5.92 Don ’ t Launch $0 Launch 5.92

6. Redesigning a Supersonic Aircraft No Restrictions.5 Restrictions.5 $25 $125.5 $100 $0 Success.6 Failure.4 $100 Redesign Do Not 80 75 50 Producing a Movie Low Cost.5 High Cost.5.4.6 $80 $10 Low Demand High Demand.4.6 $0 -$70 Low Demand High Demand Quit -$30 Produce Do Not $0 38 -42 -2 -30 4 12.6

7. SETTLE or GO TO COURT? Try to Settle Court $.4 Offer.5 $.9 Offer.2.3 $0 $1 $.6.5.6 (+.1) AcceptReject $.45 Accept Reject $.95 $.65.45.65.55 12.7

8. A RISK-AVERSE WILDCATTER Assign utility values to monetary outcomes. u($600) = 100, u(-$200) = 0.4.6 $600 -$200 Wet Dry Drill Don ’ t Drill 40 50 $0 12.8 u($0) = 50 (100) (0) (50) The risk-averse wildcatter chooses not to drill. 100 75 50 25 0 Monetary Values Utility Scale -$200 $0 $600 A risk-averse utility curve is concave.