Decisions with Discrete Random Variables: Part 2

To Lease or Not To Lease (Continued)

Using the expectation and variance from the last video, we can now make a decision as to which project was better.

To do this, we first look at their expected cash flows. We would prefer a project to have a higher expected cash flow. In the long run, if we always took projects with higher expected cash flows we would be better off. Next, we look at the variance of the cash flows. We would prefer lower variance because it means that there is less risk of large variations from our expectation.

To summarise, we prefer higher expected cash flows and lower variance. This example was nice because one of the options had a higher expectation and lower variance. In the next video, Adrian will discuss how we make a decision if one project has higher expected cash flows but also higher variance.