Decision Tree

1. An oil drilling company is considering purchase of mineral rights on a property for Rs.100 lakh. The price
includes tests to indicate whether property has type A geological formation or type B geological formation.
The company will be unable to tell the type of geological formation until the purchase is made. It is known,
however, that 40 per cent of the land in this area has type A formation, and 60 per cent type B formation. If
the company decides to drill on land, it will cost Rs.200 lakh. If the company does drill, it may hit an oil
well, gas well, or a dry hole. Drilling experience indicates that the probability of striking an oil well is 0.4
on type A and 0.1 on type B formation. Probability of hitting gas is 0.2 on type A and 0.1 on type B
formation. The estimated discounted cash value of income from an oil well is Rs.1,000 lakh and that from a
gas well is Rs.500 lakh. This includes everything except cost of mineral rights and cost of drilling. Use
decision tree approach and recommend whether the company should purchase the mineral rights.

2. The Oil India Corporation (OIC) is considering whether to go for an offshore oil drilling contract to be
awarded in Bombay High. If OIC bid, value would be Rs 600 million with a 65% chance of gaining the
contract. The OIC may set up a new drilling operation or move already existing operation, which has proved
successful, to a new site. The probability of success and expected returns are a follows:
Outcome New drilling operation Existing Operation
Probability Expected revenue Probability Expected revenue
(Rs million) (Rs million)
Success 0.75 800 0.85 700
Failure 0.25 200 0.15 350
In the Corporation do not bid or lose the contract, the can use Rs 600 million to modernise their operation.
This would result in a return of either 5 percent or 8 percent on the sum invested with probabilities 0.45 and
0.55. (Assume that all costs and revenue have been discounted to present value.)
(a) Construct a decision tree for the problem showing clearly the courses of action.
(b) By applying an appropriate decision criterion recommend whether or not the Oil India Corporation should
bid the contract.

3. A manufacturing company has just developed a new product. On a basis of past experience, a product
such as this will either be successful, with an expected gross return of Rs 1,00,000, or unsuccessful, with an
expected gross return of Rs 20,000. Similar products manufactured by the company have a record of being
successful about 50 percent of the time. The production and marketing costs of the new product are
expected to be Rs 50,000.
The company is considering whether to market this new product or to drop it.
Before making its decision, a test marketing effort can be conducted at a cost of Rs 10,000. Based on past
experience, test marketing results have been favourable about 70 percent of the time. Furthermore, products
favourably tested have been successful 80 percent of the time. However, when the test marketing result has
been unfavourable, the product has only been successful 30 percent of the time. What course of action
should the company pursue?

4. The XYZ Company manufacture guaranteed tennis balls. At present time, approximately 10 percent of the
tennis balls are defective. A defective ball leaving the factory costs the company Re 0.50 to honour its
guarantee. Assume that all defective balls are returned. At a cost of Re 0.10 per ball, the company can
conduct a test, which always correctly identifies both good and bad tennis balls.
(a) Draw a decision tree and determine the optimal course of action and its expected cost.
(b) At what test cost the company should be indifferent to testing?

5. The Ore Mining Company is attempting to decide whether or not a certain piece of land should be
purchased. The land cost is Rs 3,00,000. If there are commercial ore deposits on the land, the estimated
value of property is Rs 5,00,000. If no ore deposits exist, however, the property value is estimated at Rs
2,00,000. Before purchasing the land, the property can be cored at a cost of Rs 20,000. The coring will
indicate if conditions are favourable or unfavourable for ore mining. If the coring report is favourable the
probability of recoverable ore deposits on the land is 0.8, while if the coring report is unfavourable the
probability is only 0.2. Prior to obtaining any coring information, management estimates that the odds are
 50-50 that ore is present on the land. Management has also received coring reports on pieces of land similar
to the ore in question and found that 60 percent of the coring reports were favourable.
Construct a decision tree and determine whether the company should purchase the land, decline to purchase it,
or take a coring test before making its decision. Specify the optimal course of action and EMV.

6. XYZ company dealing with a newly invented telephone device is faced with the problem of selecting out
of the following courses of action available:
(i) manufacture the device itself; or
(ii) be paid on a royalty basis by another manufacturer; or
(iii) sell the rights for its invention for a lump sum.
The profit (in Rs ‘000s) which can be expected in each and the probabilities associated with the level of
sales are shown in the following table:
Outcome Probability Manufacture itself Royalties Sell all rights
High sales 0.1 75 35 15
Medium sales 0.3 25 20 15
Low sales 0.6 -10 10 15
Represent the company’s problem in the form of a decision tree. Redraw further the decision tree by
introducing the following additional information:
(a) If it manufactures itself and sales are medium or high, then company has the opportunity of developing a
new version of its telephone;
(b) From past experience company estimates that there is a 50 percent chance of successful development,
(c) The cost of development is Rs 15 and returns after deduction of development cost are Rs 30 and Rs 10 for
high and medium sales, respectively.

7. A farmer is considering drilling a well. In the past only 70% wells drilled were successful at 20 metres
depth in that area Moreover on finding no water at 20 metres, some person in that area drilled it up to 25
metres but only 20% struck water at that level. The prevailing cost of drilling is Rs. 500 per metre. The
farmer estimated that in case he does not get water in his own well he will have to pay Rs. 15000 to buy
water from outside for the same period of getting water from the well. Determine the farmer’s decision
strategy.

8. A company is planning to open a super bazaar in a city. The company has selected three different
locations namely location A, B and C.
Location A is in the upper class dominated locality. Here, if the project is successful, it would give net profit
of Rs. 50 Lakhs per annum, but if the project is not successful, the company would lose Rs. 65 Lakhs.
Location B is in middle class dominated locality. Here, if the project is successful, the company would get net
profit of Rs 30 Lakhs per annum but if it fails it would have annual loss of Rs. 15 Lakhs.
The third location C is on the highway, little out of city. Here, if the project is successful, would yield net
profit of Rs 15 Lakhs, and if it is unsuccessful, it would result in neither profit nor loss.
The success of a project at each location is dependent on the retail industry. If the retail industry does well,
project at any location would be successful, and if the growth in the retail industry declines the project would
not be so successful irrespective of location. There is a 60% chance that the retail industry would grow. Given
this scenario, in which location should the company open the superbazaar?

9. In the above example, suppose, a consultant who has analysed the retail industry, and is ready to
give some more facts, for a fee of Rs 1 Lakh, approaches the company for soliciting his advice .
The consultant will state the prediction about the retail industry as either ‘Favorable’ or
‘Unfavourable’.
company analysed the past history of the predictions by the consultant, and found that 90% of the times the
industry showed growth, the consultant had predicted it correctly as favourable. This is the probability of
forecast being favourable given the industry showed growth. It is also given that, 80% of the times when the
consultant predicted that the industry would be Unfavourable, the industry did not show growth. Now what
should the company decide?

10. Evelyn Parkhill is considering three possible ways to invest the $200,000 she has just inherited.
(1) Some of her friends are considering financing a combined laundromat, video-game arcade, and
pizzeria, where the young singles in the area can meet and play while doing their laundry. This
 venture is highly risky and could result in either a major loss or a substantial gain within a year.
Evelyn estimates that with probability 0.6, she will lose all of her money. However, with
probability 0.4, she will make a $200,000 profit.
(2) She can invest in some new apartments that are being built in town. Within 1 year, this fairly
conservative project will produce a profit of at least $10,000, but it might yield $15,000,
$20,000, $25,000, or possibly even $30,000. Evelyn estimates the probabilities of these five
returns at 0.20, 0.30, 0.25, 0.20. and 0.05, respectively.

(3) She can invest in some government securities that have a current yield of 8.25 percent.

(a) Construct a decision tree to help Evelyn decide how to invest her money.
(b) Which investment will maximize her expected 1-year profit?
(c) How high would the yield on the government bonds have to be before she would decide
to invest in them?
(d) How much would she be willing to pay for perfect information about the success of the
laundromat?
(e) How much would she be willing to pay for perfect information about the success of the
apartments?

11 Company A has developed a new product and has to decide whether to launch the product in the market
on its own or sell-off the rights for Rupees 60 million. The company believes that there are 50-50 chances
that the market response to the product will be very good or just about average. If the response is very good
the company expects to earn Rupees 300 million, but if just about average then only Rupees 30 million (the
present value of the future operating profits.).These earning are exclusive of the cost of initial launch of
Rupees 75 million.

Prior to a decision on launch the company has the option of test marketing the product, at a cost of Rupees 8
million. The test may give a favorable response or an unfavorable response for the product. The conditional
probabilities of the market response under the true states of very good or just average market condition are
tabulated below:
Test outcome
True market state Unfavorable Favorable
Very good 0.1 0.9
Just average 0.7 0.3
Using a Decision Tree analysis, determine the optimal policy that the company should follow.