You are on page 1of 2

What is a Decision Tree

A Visual Representation of Choices, Consequences, Probabilities, and Opportunities.
or
A Way of Breaking Down Complicated Situations Down to Easier-to-Understand Scenarios.

Decision Tree Example

.4

40% chance of good economy

Expand Factor
Cost= 1.5 million

Profit = $6 m
.6
60% chance of bad economy
Profit= $2

.4
Not Expand factory
Cost= 0 $

Good economy (40%)
Profit=$3 m

.6
Bad economy (60%)
Profit=$1 m

Year 0

Year 1

1)-1 = $0.6(1) = $1.1)-1 = $2.79 > $1.1)-1 = $5.4(3) + .8M Formula for discounting money as a function of time is: PV = S (1+i)-n Where i = interest / discount rate n = number of years S = nominal value So.82M) = $3. and that means the NPV = 3.727. = 0.4(5.638 So. the PV of the revenue streams (once you account for the time value of money) are: PVExpand =.454.73) + 0.5M) + . should you expand the factory? Yes.6(.6(1.181 c) PV = 3(1.5 = $1.4(6) + . we get the Present Value (PV) of the estimated net revenues: • a) PV = 6(1. you don’t discount it.NPVExpand = (.5 = $2.1M NPVNo Expand = . because the cost of the expansion is $1.5M.29M PVDon’t Ex.454 b) PV = 2(1.909.818.910) = 1.091 Therefore.64 Note that since the cost of expansion is borne in year 0. in each scenario. .1)-1 = $1.6(2)) – 1.4(2.272 d) PV = 1(1.29 – 1.