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# DECISION TREES

SAMPLE PROBLEMS
1. In 1995, Digital Equipment Corporation arranged to get the Cunard Lines ship
Queen Elizabeth 2 QE2! "or use as a "loating hotel "or the #ompan\$%s annual
#on&ention. 'he meeting too( pla#e in )eptember and lasted nine da\$s. In
agreeing to lease the QE2, Cunard had to ma(e a de#ision. I" the #ruise ship *ere
leased to Digital, Cunard *ould get a "lat "ee and an additional per#entage o"
pro"its "rom the gala #on&ention, *hi#h #ould attra#t as man\$ as 5+,+++ people.
Cunard anal\$sts there"ore estimated that i" the ship *ere leased, there *ould be a
+.5+ probabilit\$ that the #ompan\$ *ould ma(e ,-++,+++ "or the nine da\$s. a +./+
probabilit\$ that pro"its "rom the &enture *ould be about ,0++,+++. a +.15
probabilit\$ that pro"its *ould be about ,9++,+++. and a +.+5 probabilit\$ that
pro"its *ould be as high as ,1 million. I" the ship *ere not leased to Digital, the
&essel *ould be used "or its usual 1tlanti# #rossing &o\$age, also lasting nine da\$s.
I" this happened, there *ould be a +.9+ probabilit\$ that pro"its *ould be ,-5+,+++
and a +.1+ probabilit\$ that pro"its *ould be about ,-0+,+++. 'he tighter
distribution o" pro"its on the &o\$age *as due to the "a#t that Cunard anal\$sts (ne*
relati&el\$ little about the proposed &enture.
Curnard had one additional option. I" the ship *ere leased to Digital, and
it be#ame #lear *ithin the "irst "e* da\$s o" the #on&ention that Cunard%s pro"its
"rom the &enture *ere going to be in the range o" onl\$ ,-++,+++, the steamship
#ompan\$ #ould #hoose to promote the #on&ention on its o*n b\$ o""ering
parti#ipants dis#ounts on QE2 #ruises. 'he #ompan\$%s anal\$sts belie&ed that i"
this a#tion *ere #hosen, there *ould be a +.2+ probabilit\$ that pro"its *ould
in#rease to about ,-3+,+++ and a +.3+ probabilit\$ that the promotion *ould "ail,
lo*ering pro"its to ,20+,+++ due to the #ost o" the promotional #ampaign and the
dis#ounts o""ered. 4hat should Cunard ha&e done5
2. Commodit\$ "utures pro&ide an opportunit\$ "or bu\$ers and suppliers o"
#ommodities su#h as *heat to arrange in ad&an#e sales o" a #ommodit\$, *ith
deli&er\$ and pa\$ment ta(ing pla#e at a spe#i"ied time in the "uture. 'he pri#e is
de#ided at the time the order is pla#ed, and the bu\$er is as(ed to deposit an
amount less than the &alue o" the order, but enough to prote#t the seller "rom loss
in #ase the bu\$er should de#ide not to meet the obligation.
1n in&estor is #onsidering in&esting ,15,+++ in *heat "utures and belie&es
that there is a +.1+ probabilit\$ that he *ill lose ,5,+++ b\$ the e6piration o" the
#ontra#t, a +.2+ probabilit\$ that he *ill ma(e ,2,+++, a +.25 probabilit\$ that he
*ill ma(e ,/,+++ a +.15 probabilit\$ he *ill ma(e ,3,+++, a +.15 probabilit\$ he
*ill ma(e ,5,+++, a +.1+ probabilit\$ he *ill ma(e ,2,+++, and a +.+5 probabilit\$
that he *ill ma(e ,-,+++. I" the in&estor should "ind out that he is going to lose
,5,+++, he #an pull out o" his #ontra#t, losing ,/,5++ "or #ertain and an additional
,/,+++ *ith probabilit\$ +.2+ the latter amount deposited *ith a bro(erage "irm as
a guarantee!.
)uppose that the in&estor is #onsidering another in&estment as an alternati&e
to *heat. 7e is #onsidering in&esting his ,15,+++ in a limited partnership "or the
same duration o" time as the "utures #ontra#t. 'his alternati&e has a +.5+ #han#e o"
earning ,5,+++ and a +.5+ #han#e o" earning nothing. Dra* the de#ision tree "or
this problem, and sol&e it. 4hat should the in&estor do5
/. 'he 8il India Corporation is #onsidering *hether to go "or an o""shore drilling
#ontra#t to be a*arded in 9omba\$ 7igh. I" the\$ bid, &alue *ould be :s. 2++
million *ith a 25; #han#e o" gaining the #ontra#t. 'he Corporation ma\$ set up a
ne* drilling operation or mo&e alread\$ e6isting operation, *hi#h has pro&ed
su##ess"ul, to ne* site. 'he probabilit\$ o" su##ess and e6pe#ted returns are as
"ollo*s<
8ut#ome =e* Drilling 8peration E6isting 8peration
>robabilit\$ E6pe#ted :e&enue >robabilit\$ E6pe#ted :e&enue
:s million! :s million!
)u##ess +.-5 0++ +.05 -++
?ailure +.25 2++ +.15 /5+
I" the Corporation does not bid or lose the #ontra#t, the\$ #an use :s 2++ million to
modernize their operations. 'his *ould result in a return o" either 5; or 0; on
the sum in&ested *ith probabilities +.35 and +.55, respe#ti&el\$.
a! Constru#t a de#ision tree "or the problem sho*ing #learl\$ the #ourses o" a#tion.
b! 9\$ appl\$ing an appropriate de#ision #riterion re#ommend *hether or not the
#orporation should bid the #ontra#t.
3. 1n oil #ompan\$ has re#entl\$ a#quired rights in a #ertain area to #ondu#t sur&e\$s
and test drillings to lead to li"ting oil i" it is "ound in #ommer#iall\$ e6ploitable
quantities.
'he area is #onsidered to ha&e good potential "or "inding oil in #ommer#ial
quantities. 1t the outset, the #ompan\$ has the #hoi#e to #ondu#t "urther geologi#al
tests or to #arr\$ out a drilling programme immediatel\$. 8n the (no*n #onditions,
the #ompan\$ estimates that there is a -+</+ #han#e o" "urther tests sho*ing a
@su##ess%.
4hether the tests sho* the possibilit\$ o" ultimate su##ess or not or e&en i"
no tests are underta(en at all, the #ompan\$ #ould still pursue its drilling
programme or alternati&el\$ #onsider selling its rights to drill in the area.
'herea"ter, ho*e&er, i" it #arries out the drilling programme, the li(elihood o"
"inal su##ess or "ailure is #onsidered dependent on the "oregoing stages. 'hus<
I" @su##ess"ul% tests ha&e been #arried out, the e6pe#tation o" su##ess in
drilling is gi&en as 0+<2+
I" the tests indi#ate @"ailure%, then the e6pe#tation o" su##ess in drilling
is gi&en as 2+<0+
I" no tests ha&e been #arried out at all the e6pe#tation o" su##ess in
drilling is gi&en as 55<35
Costs and re&enues ha&e been estimated "or all possible out#omes and the net
present &alue o" ea#h is as "ollo*s<
8ut#ome =et >resent Aalue :s Billion!
)u##ess<
4ith prior tests 1++
4ithout prior tests 12+
?ailure<
4ith prior tests C5+
4ithout prior tests C3+
)ales o" e6ploitation rights<
>rior tests sho* @su##ess% 25
>rior tests sho* @"ailure% 15
4ithout prior tests 35
a! Dra* up a de#ision probabilit\$! tree diagram to represent the abo&e in"ormation.
and
b! E&aluate the tree in order to ad&ise the management o" the #ompan\$ on its best
#ourse o" a#tion.
5. Insuran#e #ompanies need to in&est large amounts o" mone\$ in opportunities that
pro&ide high \$ields and are longCterm. 8ne t\$pe o" in&estment that has re#entl\$
attra#ted some insuran#e #ompanies is real estate.
1etna Li"e and Casualt\$ Compan\$ is #onsidering an in&estment in real estate
in #entral ?lorida. 'he in&estment is "or a period o" 1+ \$ears, and #ompan\$
anal\$sts belie&e that the in&estment *ill lead to returns that depend on "uture
le&els o" e#onomi# a#ti&it\$ in the area. In parti#ular, the anal\$sts belie&e that the
in&ested amount *ould bring the pro"its listed in 'able belo* depending on the
listed le&els o" e#onomi# a#ti&it\$ ant their gi&en prior! probabilit\$.
>ro"it "rom in&estment Le&el o" e#onomi# a#ti&it\$ >robabilit\$
, / m Lo* .2+
, 2 m Bedium .5+
, 12 m 7igh ./+
'he alternati&e to this in&estment planCone that the #ompan\$ has used in the
pastCis a parti#ular in&estment that has a +.5 probabilit\$ o" \$ielding a pro"it o" ,3
million and a +.5 probabilit\$ o" \$ielding ,-million o&er the period in question.
'he #ompan\$ ma\$ also see( some e6pert ad&i#e on e#onomi# #onditions in
#entral ?lorida. ?or an amount that *ould be equi&alent to,1++,+++ ten \$ears
"rom no* *hen in&ested at a ris(C"ree rate!, the #ompan\$ #ould hire an e#onomi#
#onsulting "irm to stud\$ the "uture e#onomi# prospe#ts in #entral ?lorida. ?rom
past dealings *ith the #onsulting "irm, 1etna anal\$sts belie&e that the reliabilit\$ o"
the #onsulting "irm%s #on#lusions is as listed in 'able belo*.
Consultant%s #on#lusion
'rue "uture state o" e#onom\$ 7igh Bedium Lo*
Lo* +.+5 +.+5 +.9+
Bedium +.15 +.0+ +.+5
7igh +.05 +.1+ +.+5
'he table lists as #olumns the three #on#lusions the #onsultants ma\$ rea#h
about the "uture o" the area%s e#onom\$. 'he ro*s o" the table #orrespond to the
true le&el o" the e#onom\$ 1+ \$ears in the "uture, and the table entries are
#onditional probabilities. ?or e6ample, i" the "uture le&el o" the e#onom\$ is going
to be high, then the #onsultant%s statement *ill be DhighE *ith probabilit\$ +.05
4hat should 1etna do5
2. Ban\$ airlines "l\$ing o&erseas ha&e re#entl\$ #onsidered #hanging the (inds o"
goods the\$ sell at their inC"light dut\$C"ree ser&i#es. )*issair, "or e6ample, is
#onsidering selling )*iss *at#hes instead o" the usual liquor and #igarettes. 1
)*issair e6e#uti&e belie&es that there is a +.2+ #han#e that passengers *ould
pre"er theses goods to the usual items and that re&enues "rom inC "light sales
*ould in#rease b\$ ,3+,+++ o&er a period o" se&eral months. )he belie&es there is
a +.3+ #han#e that re&enues *ould de#rease b\$ ,2+,+++, *hi#h *ould happen
should people not bu\$ the *at#hes and instead desire the usual items. 'esting the
ne* idea on a#tual "lights *ould #ost ,2,+++, and the results *ould ha&e a +.05
probabilit\$ o" #orre#tl\$ dete#ting the state o" nature.
4hat should )*issair do5