Rizaldy R.

Raguero, CPA, MBA, CTT

DECISION ANALYSIS

TYPES OF DECISION

DECISION UNDER CONDITION OF UNCERTAINTY

DECISION UNDER CONDITION OF RISK

DECISION TREE
 WHAT IS
DECISION ANALYSIS ?
Decision analysis (DA) is a form of decision-
making that involves identifying and assessing
all aspects of a decision, and taking actions
based on the decision that produces the most
favorable outcome.
 TYPES OF DECISION
DECISION MAKING UNDER CONDITION OF UNCERTAINTY
Each decision alternative has several events or
outcomes. The probability distribution of the
possible future states of nature is not known and
must be determined subjectively.
DECISION MAKING UNDER CONDITION OF RISK

The probability distribution of the possible future

DECISION MAKING UNDER CERTAINTY states of nature is known
For each decision alternative , there is only one
event, and therefore only one outcome. The event
has a 100% chance of occurrence.
BASIC TERMS IN DECISION ANALYSIS
DECISION ALTERNATIVE
These are the options available for the decision
maker to choose from.
STATES OF NATURE or OUTCOMES
These are the uncontrollable conditions that may
take place upon decision
PAY-OFFS
The value assigned to the different outcomes
from a decision
DECISION MAKING UNDER CONDITION OF UNCERTAINTY
Mr. H would like to invest in one financial instrument. A financial analyst provided him with the past year rate of return for
the three options: (1) Bonds, (2) Stocks and (3) Mutual Funds

Stocks Growing Stable Declining

Bonds 45 45 5
Stocks 70 30 -13
Mutual Funds 53 45 -5
DECISION MAKING UNDER CONDITION OF UNCERTAINTY

Compare the best pay-off for each alternative. This means that your decision is based on the highest return that you can
get under the best favorable condition.

Stocks Growing Stable Declining

Bonds 47 45 5 47
Stocks 70 30 -13 70
Mutual Funds 53 45 -5 53

DECISION
Invest on Stocks because it will give you the
highest return if the best condition happen
DECISION MAKING UNDER CONDITION OF UNCERTAINTY

Compare the worst pay-off for each alternative. This means that your decision is based on the highest return that you can
get under the most unfavorable condition.

Stocks Growing Stable Declining

Bonds 47 45 5 5
Stocks 70 30 -13 -13
Mutual Funds 53 45 -5 -5

DECISION
Invest on Bonds because it will give you the
highest return if the worst condition happen
DECISION MAKING UNDER CONDITION OF UNCERTAINTY

Compare the regret for each for each alternative. This means that your decision is based on the minimum regret

Stocks Growing Stable Declining

Bonds 47 45 5
Stocks 70 30 -13
Mutual Funds 53 45 -5 DECISION
Invest on Mutual Fund because it will
Stocks Growing Stable Declining give you the lowest regret among the
Bonds 23 0 0 23 three alternatives
Stocks 0 15 18 18
Mutual Funds 17 0 10 17
DECISION MAKING UNDER CONDITION OF RISK

The expected value of an action is calculated by multiplying the probability of each outcome by its pay-off and
summing the products. Expected value represents the long-term average pay-off from repeated trials.

Stocks Growing Stable Declining

Bonds 47 45 5
Stocks 70 30 -13
Mutual Funds 53 45 -5
Probability 20% 50% 30%

Bonds = (0.20x47)+(0.50x45)+(0.30x5) = 33.40

Stocks = (0.20x70)+(0.50x30)+(0.30x-13) = 25.10
Mutual Funds = (0.20x53)+(0.50x45)+(0.30x-5) = 31.60

Invest on Bonds because it will give you the

DECISION highest EMV
DECISION MAKING UNDER CONDITION OF RISK

Perfect Information – the knowledge that a future state of nature (event) will occur
with certainty. In this case it is assumed that the probability distribution is an
accurate representation of the relative frequency of future demand and that the
decision maker knows exactly when each possible event will occur.

Expected Value of Perfect Information (EVPI) – the difference between the

expected value without perfect information and the result if the best action is
taken given perfect information.
DECISION MAKING UNDER CONDITION OF RISK

If the financial manager provides the accurate probable distribution. How much will be the cost of perfect
information?

Stocks Growing Stable Declining

Bonds 47 45 5
Stocks 70 30 -13
Mutual Funds 53 45 -5
Probability 20% 50% 30%

EMVwPI = (0.20x70)+(0.50x45)+(0.30x5) = 38
EMVwoPI = (0.20x47)+(0.50x45)+(0.30x5) = 33.40
Expected Value of Perfect information = 4.60
DECISION TREE

A graphic representation of the decision points, the alternative courses of action

available to the decision maker, and the possible outcomes from each alternative, as
well as the relative probabilities and the expected values of each event

Decision Points (Decision Nodes) – the points at which the decision maker must
choose some action

Chance Points (State of Nature Nodes/Probability Nodes) – the points at which some
event related to the previous decision will occur
 EMV
Growing: (0.20 x 47) = 9.4 9.40

Bonds 33.40 Stable: (0.50 x 45) = 22.5 22.50

Declining: (0.30 x 5) = 1.5 1.50 33.40

Growing: (0.20 x 70) = 14 14.00

33.40 Stable: (0.50 x 30) = 15
Stocks 25.10 15.50

Declining: (0.30 x -13) = -3.90 -3.90 25.10

Bonds
Growing: (0.20 x 53) = 10.60 10.60

31.60 Stable: (0.50 x 45) = 22.5 22.50

Mutual Funds Declining: (0.30 x -5) = -1.5 -1.50 31.60

Invest on Bonds because it will give you the

DECISION highest EMV
BREAK
OUT
ROOM
BREAK
OUT
ROOM
Go to Assignment and answer
Q No 5
When to submit: 11 pm on the day of
your Asynchronous class
Go to: Assignment, Answer: SA5