Decision Trees for Decision Making

Prof. Anjali M. Kulkarni

Decision Tree
y A graphical depiction of the sequences of event/ action y y y y

combinations in a systematic manner. Used for sequential decisions, rather than a single decision. A tree is composed of squares, circles and lines. Squares indicate decision points and circles represent chance events. The lines or branches emanating from a square indicates alternatives while those emanating from circles indicate states of nature.

Decision Tree Format

s1 s2 Payoff 1,1 Payoff 1,2 Payoff 1,3 Payoff 2,1 s2 s3 Payoff 2,2 Payoff 2,3 Payoff 3,1 s2 s3 Payoff 3,2 Payoff 3,3

a1 a1

S3

s1

a1

s1

Example
y Unicom Inc. is adding a new product. In order to accommodate the anticipated capacity

need of the new product, the firm believes that a new plant must be built. The firm has to make a decision to build a large plant or a small plant. In either case, demand will be either favourable or unfavourable with probabilities of 0.55 and 0.45 resp. If a large plant is built and demand is favourable, the NPV of returns is estimated at Rs. 15,00,000. if demand is unfavourable, the net loss with the large plant is estimated to be Rs. 50,000.
y If a small plant is built and demand is unfavourable, the NPV is Rs. 70,000. if demand

proves to be favourable, the firm can either maintain the small plant or expand it. Maintaining the small plant has a NPV of Rs. 950,000. if the firm decides to expand, the firm can expect a high return or a low return. There is a 40% chance of earning a NPV of Rs. 1330,000 (high return) and a 60% chance of earning Rs. 720,000 (low return).
y Draw a decision tree for this problem. y Calculate all of the necessary expected values and determine the best course of action for

management.

Decision Tree
700,000 950,000 2 5 1 720,000 1500,000 1330,000 3

4
-50,000

Solution
y Starting from Node 1, expected return is given by y EMV1 = 0.4 x 1330,000 + 0.6 x 720,000 = Rs. 964000 y Since the expected monetary value of expansion is greater

than the EMV of maintaining the current size, we choose to expand. y At node 3, y EMV3 = 0.45 x 700,000 + 0.55 x 964000 = Rs. 845,200
y At node 4, y EMV4= 0.55 x 1500,000 + 0.45 x (-50000) = Rs. 802,500

Decision Tree
700,000 950,000 964000 2 964000 5 1 720,000 1500,000 1330,000 3

4
-50,000

Decision Tree
700,000 950,000 964000 2 845,200 5 964000 1 720,000 1500,000 1330,000 3

4
-50,000

Solution
y When we compare node 3 and 4, EMV of building a small

plant is higher. Therefore we conclude that Unicom Inc. should choose to build a small plant, and if the demand is favourable, the company should choose to expand. The overall net return for the company is Rs. 845,000.

Question 1
y A businessman has two independent investments A & B

available to him but he lacks the capital to undertake both simultaneously. He can choose to take A first and then stop or if A is successful then take B or vice versa. The probability of success of A is 0.7 while for B it is 0.4. both investments require an initial capital outlay of Rs. 200000 and both return nothing if unsuccessful. Successful completion of A will return Rs. 30000 over cost and the successful completion of B will return Rs. 15000 over cost . Draw the decision tree and determine best strategy.

Question 2
y Sanchar Ltd. Is dealing with a newly invented telephone device, is faced

with the problem of selecting from the following courses of action: (a) Manufacture the device themselves (b) Manufacture by another party on royalty basis (c) Sell the rights of the invention for a lump sum y The expected profits in Rs. Lacs at different levels are as belowOutcome High sales Medium sales Low sales Probability 0.1 0.3 0.6 Option a 75 25 -10 Option b 35 20 10 Option c 15 15 15

Q. 2 Continued
y Represent the companys problem in the form of a decision

tree. Give your decision on this. y Redraw the tree with following further information: (a) If the company manufactures the product ands sales are medium or high then the company has opportunity of developing a new version of the telephone. (b) From past experience, the company estimates that there is a 50% chance of successful development. (c) The cost of development is Rs. 15 lacs and the returns after deducting the development costs are Rs. 30 lacs and Rs. 10 lacs for high and medium sales resp.