4 Decision Tree Analysis

Decision Analysis
Chapter 12
Copyright © 2016 Pearson Education, Ltd. 12-1

Chapter Topics
■ Components of Decision Making

■ Decision Making Without Probabilities
■ Decision Making With Probabilities

Decision Analysis
Overview
▪ Previous chapters used an assumption of certainty with regards to

problem parameters.
▪ This chapter relaxes the certainty assumption
▪ Two categories of decision situations:
▪ Probabilities can be assigned to future occurrences
▪ Probabilities cannot be assigned to future occurrences

Decision Analysis
Components of Decision Making
■ A state of nature is an actual event that may occur in the future.
■ A payoff table is a means of organizing a decision situation,
presenting the payoffs from different decisions given the various
states of nature.
Table 12.1 Payoff table

Decision Analysis
Decision Making Without Probabilities
Figure 12.1 Decision

situation with real estate
investment alternatives

Decision Analysis
Decision Making without Probabilities
Table 12.2 Payoff table for the real estate investments
Decision-Making Criteria
maximax maximin minimax
minimax regret Hurwicz equal likelihood
Maximax Criterion
In the maximax criterion the decision maker selects the decision
that will result in the maximum of maximum payoffs; an
optimistic criterion.
Table 12.3 Payoff table illustrating a maximax decision

Maximin Criterion
In the maximin criterion the decision maker selects the decision
that will reflect the maximum of the minimum payoffs; a
pessimistic criterion.
Table 12.4 Payoff table illustrating a maximin decision

Minimax Regret Criterion
▪ Regret is the difference between the payoff from the best
decision and all other decision payoffs.
▪ Example: under the Good Economic Conditions state of nature,
the best payoff is $100,000. The manager’s regret for choosing
the Warehouse alternative is $100,000-$30,000=$70,000
Table 12.5 Regret table

Minimax Regret Criterion
▪ The manager calculates regrets for all alternatives under each
state of nature. Then the manager identifies the maximum
regret for each alternative.
▪ Finally, the manager attempts to avoid regret by selecting the
decision alternative that minimizes the maximum regret.
Maximize
regret
$50,000 √
$70,000
$70,000
Table 12.6 Regret table illustrating the minimax regret decision

Hurwicz Criterion
▪ The Hurwicz criterion is a compromise between the maximax
and maximin criteria.
▪ A coefficient of optimism, , is a measure of the decision
maker’s optimism.
▪ The Hurwicz criterion multiplies the best payoff by  and the
worst payoff by 1- , for each decision, and the best result is
selected. Here,  = 0.4.
Decision Values
Apartment building $50,000(.4) + 30,000(.6) = 38,000
Office building $100,000(.4) - 40,000(.6) = 16,000
Warehouse $30,000(.4) + 10,000(.6) = 18,000

Equal Likelihood Criterion
The equal likelihood ( or Laplace) criterion multiplies the

decision payoff for each state of nature by an equal weight, thus
assuming that the states of nature are equally likely to occur.
Decision Values
Apartment building $50,000(.5) + 30,000(.5) = 40,000
Office building $100,000(.5) - 40,000(.5) = 30,000
Warehouse $30,000(.5) + 10,000(.5) = 20,000

Summary of Criteria Results
■ A dominant decision is one that has a better payoff than another
decision under each state of nature.
■ The appropriate criterion is dependent on the “risk” personality
and philosophy of the decision maker.
Criterion Decision (Purchase)
Maximax Office building
Maximin Apartment building
Minimax regret Apartment building
Hurwicz Apartment building
Equal likelihood Apartment building

Solution with Excel
=MIN(C7,D7)
=MAX(E7,E9)
=MAX(F7:F9)
=MAX(C18,D18)
=MAX(C7:C9)-C9
=C7*C25+D7*C26
=C7*0.5+D7*0.5
Exhibit 12.4
Decision Making with Probabilities
Expected Value
▪ Expected value is computed by multiplying each decision
outcome under each state of nature by the probability of its
occurrence.
Table 12.7 Payoff table with probabilities for states of nature
EV(Apartment) = $50,000(.6) + 30,000(.4) = $42,000

EV(Office) = $100,000(.6) - 40,000(.4) = $44,000
EV(Warehouse) = $30,000(.6) + 10,000(.4) = $22,000
Expected Opportunity Loss
■ The expected opportunity loss is the expected value of the
regret for each decision.
■ The expected value and expected opportunity loss criterion
result in the same decision.
EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000
EOL(Office) = $0(.6) + 70,000(.4) = 28,000
EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
Table 12.8 Regret table with probabilities for states of nature

Expected Value Problems
Solution with Excel
Expected value for

apartment building
Exhibit 12.6
Expected Value of Perfect Information
■ The expected value of perfect information (EVPI) is the

maximum amount a decision maker would pay for additional
information.
■ EVPI equals the expected value given perfect information

minus the expected value without perfect information.
■ EVPI equals the expected opportunity loss (EOL) for the best
decision.

EVPI Example (1 of 2)
Table 12.9 Payoff table with decisions,

given perfect information

EVPI Example (2 of 2)
■ Decision with perfect information:

$100,000(.60) + 30,000(.40) = $72,000
■ Decision without perfect information:

EV(office) = $100,000(.60) - 40,000(.40) = $44,000
EVPI = $72,000 - 44,000 = $28,000

EOL(office) = $0(.60) + 70,000(.4) = $28,000

Decision Trees (1 of 4)
A decision tree is a diagram consisting of decision nodes
(represented as squares), probability nodes (circles), and
decision alternatives (branches).
Table 12.10 Payoff table for real estate investment example

A decision tree is a
diagram consisting
of:
• decision nodes
(represented as
squares)
• probability nodes
(circles)
• decision alternatives
(branches)
Figure 12.2 Decision tree for real estate investment example

■ The expected value is computed at each probability node:

EV(node 2) = .60($50,000) + .40(30,000) = $42,000
EV(node 3) = .60($100,000) + .40(-40,000) = $44,000
EV(node 4) = .60($30,000) + .40(10,000) = $22,000
■ Branches with the greatest expected value are selected.

Figure 12.3 Decision tree with expected value at probability nodes

Decision Trees with Excel and TreePlan (1 of 4)
Exhibit 12.10

To create another branch, click
“B5,” then the “Decision Tree” Invoke TreePlan from
menu, and select “Add Branch” the “Add Ins” menu
Exhibit 12.11
Click on cell “F3,”

then “Decision Tree”
Select “Change to
Event Node” and add
two new branches
Exhibit 12.12
Add numerical dollar and probability
values in these cells in column H
Exhibit 12.13
These cells contain decision tree

formulas; do not type in these
cells in columns E and I
Sequential Decision Trees (1 of 4)
■ A sequential decision tree is used to illustrate a situation
requiring a series of decisions.
■ Used where a payoff table, limited to a single decision, cannot

be used.
■ The next slide shows the real estate investment example

modified to encompass a ten-year period in which several
decisions must be made.

Figure 12.4 Sequential decision tree

■ Expected value of apartment building is:

$1,290,000-800,000 = $490,000
■ Expected value if land is purchased is:

$1,360,000-200,000 = $1,160,000
■ The decision is to purchase land; it has the highest net expected

value of $1,160,000.

Figure 12.5 Sequential decision tree with nodal expected values

Sequential Decision Tree Analysis
Solution with TreePlan
Exhibit 12.16

4 Decision Tree Analysis

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Decision Analysis

Copyright © 2016 Pearson Education, Ltd. 12-1

■ Components of Decision Making

Copyright © 2016 Pearson Education, Ltd. 12-2

▪ Previous chapters used an assumption of certainty with regards to

Copyright © 2016 Pearson Education, Ltd. 12-3

Table 12.1 Payoff table

Figure 12.1 Decision

Copyright © 2016 Pearson Education, Ltd. 12-5

Table 12.2 Payoff table for the real estate investments

Table 12.3 Payoff table illustrating a maximax decision

Table 12.4 Payoff table illustrating a maximin decision

Copyright © 2016 Pearson Education, Ltd. 12-8

Table 12.5 Regret table

Copyright © 2016 Pearson Education, Ltd. 12-9

Table 12.6 Regret table illustrating the minimax regret decision

Office building $100,000(.4) - 40,000(.6) = 16,000

Warehouse $30,000(.4) + 10,000(.6) = 18,000

The equal likelihood ( or Laplace) criterion multiplies the

Office building $100,000(.5) - 40,000(.5) = 30,000

Warehouse $30,000(.5) + 10,000(.5) = 20,000

Copyright © 2016 Pearson Education, Ltd. 12-12

Copyright © 2016 Pearson Education, Ltd. 12-13

Table 12.7 Payoff table with probabilities for states of nature

EV(Apartment) = $50,000(.6) + 30,000(.4) = $42,000

Table 12.8 Regret table with probabilities for states of nature

Expected value for

■ The expected value of perfect information (EVPI) is the

■ EVPI equals the expected value given perfect information

Copyright © 2016 Pearson Education, Ltd. 12-18

Table 12.9 Payoff table with decisions,

Copyright © 2016 Pearson Education, Ltd. 12-19

■ Decision with perfect information:

■ Decision without perfect information:

EVPI = $72,000 - 44,000 = $28,000

Copyright © 2016 Pearson Education, Ltd. 12-20

Table 12.10 Payoff table for real estate investment example

Figure 12.2 Decision tree for real estate investment example

■ The expected value is computed at each probability node:

■ Branches with the greatest expected value are selected.

Copyright © 2016 Pearson Education, Ltd. 12-23

Figure 12.3 Decision tree with expected value at probability nodes

Copyright © 2016 Pearson Education, Ltd. 12-25

Click on cell “F3,”

These cells contain decision tree

■ Used where a payoff table, limited to a single decision, cannot

■ The next slide shows the real estate investment example

Copyright © 2016 Pearson Education, Ltd. 12-29

Figure 12.4 Sequential decision tree

■ Expected value of apartment building is:

■ Expected value if land is purchased is:

■ The decision is to purchase land; it has the highest net expected

Copyright © 2016 Pearson Education, Ltd. 12-31

Figure 12.5 Sequential decision tree with nodal expected values

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