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Similarly, there is 10 per cent probability that all conditions will be unfavourable and yields cash flow of Rs. The probability distribution shows that there is 10 per cent probability that all determining conditions work in favour of the investment project which yields cash flow of Rs. One of the other three cash flows will occur if some factors work in favour of the firm’s project A and others unfavourable to it. 30 lakhs whose probability of occurrence is also 0.1 or 10 per cent. On the other hand, if all conditions are unfavourable for the firm, its cash flow from the investment project will be Rs. We explain below the meaning of these two concepts. With the use of these two concepts we compare the profitability of various strategies involving risk and uncertainty which helps us to make a choice among them. In whatever way the probability is arrived at, it helps us to measure two important concepts, namely, expected value and variability of outcome. Obviously, when probability is subjectively determined and not based on the past data, the different individuals will attach different probabilities to the occurrence of various outcomes and therefore they will make different choices. The subjective probability is an individual’s personal view about the chance of an outcome to occur and is based on his personal judgement, experience or knowledge about the subject and not on the frequency with which outcome actually took place in the past. In that case the concept of subjective probability is used. The measurement of probability based on the past experience is generally known as the objective measure of probability.īut in many cases there are no similar past situations which help us in measuring probability. Thus, in our example if we know from the past data of oil exploration that rate of success is 25 per cent, then the probability of getting success is 1/4 or 0.25. In general, if a situation is repeated over a large number of times, say M, and if an outcome, say X, occurs m times, then If past information or data is available regarding occurrence of outcomes or events, the probability is defined as the proportion of times an outcome occurs if the situation is repeated in the long run over and over again. The first is the frequency concept of probability. These are two concepts of probability depending on how it is measured. Thus probability is a number that indicates the likelihood of an event or outcome occurring. 10 per share price, if the past information reveals that the chance of oil exploration being successful is 1/4 or 25 per cent and chance of its failure is 3/4, then we say the probability of success of oil exploration is 25 per cent and the probability of its failure is 75 per cent (The success and failure are the two possible outcomes). Given these two possible outcomes, namely, Rs. 50 per share and if its exploration meets with a failure, the company’s stock will fall to Rs. If the exploration is successful, the price of company’s stock will rise to Rs.
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For example, suppose a person is considering to invest in a company which is engaged in the new exploration of offshore oil.
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Thus, if possibility of an outcome occurring is 1/4 or 0.25, this means that there is 1 chance in 4 or 25 per cent chance for the outcome to occur.