Decision Tree

Decision Trees for Capacity Analysis

• A decision tree is a schematic model of the sequence
of steps in a problem – including the conditions and
consequences of each step.
• Decision trees help analysts understand the problem
and assist in identifying the best solution.
• Decision tree components include the following:
– Decision nodes – represented with squares
– Chance nodes – represented with circles
– Paths – links between nodes
Multistage Decision Making (Decision Tree)
A graphic representation of the sequences of actions-event combination available to the decision maker.

a t ure 1 Payoff 1
of n
Decision Point State
Chance Event oo s e A’ 1 Payoff 2
Ch
A’ State
se o f natu 2
o o re 2
h Choose Payoff 3
C A’2
B
1
h oo s e A’ 3 Payoff 4
1 C
a t ur e
e of n
Ch

2
Stat
oo
se

Choose Payoff 5
A’4
A’ 2

State
o f n at u Payoff 6
re 2
 Problem 1

A firm owner is considering of drilling a farm

well . In the past only 70% of wells drilled
were successful at 200 ft. Moreover on
finding no water at 200 ft some drilled it
further 50 ft but only 20% struck water at
250 ft. The prevailing cost of drilling is Rs.
50 per feet. The farm owner has estimated
that in case he does not get his own wells
he will have to pay Rs. 15000 over next 10
years to buy water from neighbor.
Problem 1

ir ll
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Test
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Problem 1

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Problem 1

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3 65
Sell
Test 0. 7 )
t i v e (
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Drill
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Problem 1

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Test 0. 7 )
t i v e (
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Drill Succe
(0.8)
ss 100
se
ll

Nega
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45
Problem 1

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3 65 -50
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t i v e (
Po si 2
Drill Succe
(0.8)
ss 100
se
ll

Drill
Nega
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45
Sell 15
Problem 1

re -40
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3 65 -50
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Test 0. 7 )
t i v e (
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(0.8)
ss 100
se

(0.8)
ll

Drill Failu
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tiv e(0.3) 1
45 Succe
ss 100
Sell 15
(0.2)
Node 1
Outcome Prob. Conditional Value Expected Value
1. Drill Success 0.2 100 20
Failure 0.8 -50 -40
Total -20
2. Sell 1.0 15 15
Node 2
Outcome Prob. Conditional Value Expected Value
1. Drill Success 0.8 100 80
Failure 0.2 -50 -10
Total 70
2. Sell 1.0 65 65
Node 3
Outcome Prob. Conditional Value Expected Value
1. Drill Success 0.55 120 66
Failure 0.45 -40 -18
Total 48

2. Test Positive 0.70 70 49

Negative 0.30 15 4.5
Total 53.5

3. Sell 1.0 45 45
 Problem 2
An oil company has recently acquired rights in a certain area to conduct
surveys and test drillings to lifting oil if it is found in commercially exploitable
quantities.
On the known conditions, the company estimates that there is 70:30 chances of
tests showing success.
If successful test is carried out expectation of success in drilling is 80:20.e been
If test indicates failure expectation of success drilling is 20:80
If no test have been carried out expectation of success drilling is 20:80
Company has the option of testing,driiling without testing or selling rights to
other company.
Cost and revenues have been estimated for all possible outcomes and the net
present value of each is as follows
Outcome NPV(in millions)
Success With prior test 100
Without prior test 120

Failure With prior test -50

Without prior test -40
Sale of exploitation rights
Prior test shows success 65
Prior test shows failure 15
Without prior test 45
Node 1
Outcome Prob. Conditional Value Expected Value
1. Drill Success 0.2 100 20
Failure 0.8 -50 -40
Total -20
2. Sell 1.0 15 15
Node 2
Outcome Prob. Conditional Value Expected Value
1. Drill Success 0.8 100 80
Failure 0.2 -50 -10
Total 70
2. Sell 1.0 65 65
Node 3
Outcome Prob. Conditional Value Expected Value
1. Drill Success 0.55 120 66
Failure 0.45 -40 -18
Total 48

2. Test Positive 0.70 70 49

Negative 0.30 15 4.5
Total 53.5

3. Sell 1.0 45 45
Problem 3
• The owner of Hackers Computer Store is evaluating three
options – expand at current site, expand to a new site, do
nothing.
• Decision to be taken based on 5 years projection.
• The decision process includes the following assumptions and
conditions.
• Strong growth has a 55% probability
• New site cost is $210,000
• Payoffs: strong growth = $195,000(per annum); weak growth
= $115,000(pa)
• Expanding current site cost is $87,000 (in either year 1 or 2)
• Payoffs: strong growth = $190,000; weak growth = $100,000
• Do nothing
• Payoffs: strong growth = $170,000; weak growth = $105,000
Decision Trees
• Calculate the value of each alternative
Decision Trees
• Diagram the problem chronologically
Events

Decision
Decision
Decision Trees
• Calculate value of each branch
$765,000

$365,000

$863,000

$413,000

$843,000

$850,000

$525,000
 Decision tree
• Work backwards to calculate the value of each decision/event

$765,000

$365,000

$660,500 $863,000

$413,000
Do nothing = $703,750
$843,000
Do nothing has higher value Do nothing = $850,000
$703,750
than expand or move, so $850,000
choose to do nothing
$525,000 Do nothing has higher
value than expand, so
choose to do nothing