For the given probabilities of playing the situation, the expected monetary value (aggravated sum) should be calculated. For the most acceptable alternative, we choose the alternative that has the highest expected monetary benefit.
Faced with the situation in which he/she has to make a decision in conditions of risk, the decision-maker can choose to be guided by the criterion of expected monetary value. The higher the expected monetary value of the investment, the more desirable the option.
What Is the EMV Calculator?
EMV Calculator is an easy-to-use tool that is employed for the calculation of expected monetary value (EMV). In the text below, you can find out more about the EMV formula and where is it used. So, read on to learn more!
EMV Formula
Below is the formula you need to use when calculating EMV:
EMV = Probability of occurrence * Impact of occurrence
Example:
We prepared an example for you so that you can understand it better:
- Impact of Occurrence: $10,000
- Probability of Occurrence: 6%
For these values, the EMV will be as follows:
EMV = 6% * 10,000EMV = 6 * 10,000 / 100EMV = 600
EMV and Risk Analysis
The function of monetary value is not universal but it varies from individual to individual. It depends on the overall wealth of the decision-maker. Depending on the means at its disposal and psychological characteristics, each individual will construct a function that will be specific in both inclination and shape so that it will differ from the functions of other individuals.
A value of $5,000, for example, can have a utility of 700 units for someone. However, although the value of $2,500 is indeed twice less than the value of $5,000, the other net value may feature 400 units on the utility dimension. Thus, although net values are in a linear relationship, their associated utility is not – in our example, 400 is not twice less than 700, right?
The obtained form of the function reveals the attitude of the decision-maker towards risk, more precisely the principled reluctance towards risk. The slope of the function shows that with the increase in the available amount of money, the significance increases as well (this significance is called the differential threshold in psychology). This way the observation of the decline of marginal utility prepares the stage for the later development of decision theory.
Requirements before the Risk Analysis
A set of rigorous requirements (axioms) has been set before the risk analysis, so the decision-maker needs to regulate his preferences. They have shown that any decision-maker who acts in accordance with these axioms implicitly follows the principle of maximizing expected utility. In order to be rational, the preferences must meet the following conditions:
Asymmetry
When comparing two options, the decision-maker cannot simultaneously prefer the first over the second and the second over the first. So, if there are two options, you cannot prefer the former over the latter or the latter over the former.
Transitivity
It is used when comparing three options. If the decision-maker prefers the first over the second option and the second over the third one, then the first option must be considered better than the third.
Completeness
When comparing two options, the decision-maker either prefers one over the other or the other over the first or is indifferent. If the above axioms apply, then, under conditions of certainty, the decision-maker can make a rational decision. By comparing options by pairs, he forms a sequence (ranking list) of options by priority, expressing his preferences and maximizing his benefit by choosing the first one from the ranking list.
Traditional Methods of Project Evaluation
In this section, we will describe some traditional methods for project evaluation:
- Conservative method of adjustment
With this method, the project manager is concerned about the risk associated with the project itself. So he does not use the best (most likely) estimates of variables, but those that are a little more conservative (rigorous). The manager wants to know if the project will be more acceptable with these conservative estimates.
- Pessimistic-optimistic method
This method uses pessimistic, most likely, and optimistic estimates for all or only some variables that are relevant to the project. Pessimistic assessment refers to the occurrence of undesirable consequences, while optimistic assessment refers to the occurrence of desired consequences. This means that the project manager calculates both the pessimistic (the most probable) and optimistic value of the criteria when making the final decision.
- Risk-discount method
It implies the use of an interest rate that should reflect the degree of risk associated with the observed project. The higher the risk, the higher the interest rate. Here, the project manager inserts a higher interest rate into the budget and observes the effects of this change on the value of the profit.
- Expected monetary value method
The criterion of expected monetary value (EMV) has been explained earlier. It involves selecting the project with the highest expected monetary value. As this choice is not reliable and can lead to the selection of a project with undesirable consequences, it is advisable to include a standard deviation (if this information is available to us) in the project evaluation process.
- Expectation-variance method
The procedure of the expectation-variance method implies the inclusion in the project evaluation of both the expected values and standard deviations.
Pros and Cons of Risk Analysis
Advantages
- It involves using the estimated distributions of all relevant variables that affect the criterion variable. This comes in handy when determining the probability distribution and applying the full information contained in the allocation for the purpose of project evaluation. Therefore, risk analysis is much more suitable for project evaluation than methods that base the evaluation process only on individual assessments.
- This is an effective way of fitting subjective inputs into the analysis process.
- It includes a framework for identifying factors affecting the project.
- Effective communication between several people (involved in the project evaluation) who must cooperate in the process of estimating the probability distribution.
Disadvantages
The evaluation of the project itself is done based on the distribution of the probability of the criterion variable, which is obtained through risk analysis. As a decision-maker, you do not consider certain consequences of the project explicitly in a formal way.
While you may have your own preferences for some of the consequences, you don’t judge them based on preferences or utility functions. Therefore, it cannot include them in the analysis and evaluation of the project.