PROBABILITY AND DECISION TREE

By
Okite Moses
 What is a Decision Tree?
• It is a Visual Representation of Choices, Consequences,
Probabilities, and Opportunities.
• It’s a Way of Breaking Down Complicated Situations
Down to Easier-to-Understand Scenarios.
• Can be used instead of a table to show alternatives,
outcomes, payoffs and calculate Expected Monetary
Value
 Therefore a Decision Tree is…
A diagrammatic/graphical tool for describing;

1.the actions available to the decision-maker,

2.the events that can occur, and

3.the relationship between the actions and

events.
 Notation Used in Decision Trees
• A box is used to show a choice that the manager has to
make.
(Decision Point or Decision node)

• A circle is used to show that a probability outcome will

occur.
(Chance event or chance node)

• Lines connect outcomes to their choice

or probability outcome.
(Decision Branch & Chance branch)

• Triangle At the end of each branch is a triangle

where a payoff will be identified.
(Endpoint)
 Decision Trees analysis Steps
• Draw the decision tree using squares to
represent decisions and circles to
represent uncertainty,
• Evaluate the decision tree to make sure
all possible outcomes are included,
values).

5
 Decision Trees analysis Steps
Calculate the tree values working from
the right side back to the left,
Calculate the values of uncertain
outcome nodes by multiplying the value
of the outcomes by their probability (i.e.,
expected.
Determine the best decision for the tree
by starting at its root and going forward
6
 Example Decision Tree

Chance
Event 1
node
Decision ision1 Event 2
De c
node Event 3
Deci
sion
2

Note:
1. Create the decision tree from left to right
2. Solve the decision tree from right to left. This involves
calculating the expected value at each step
 A larger tree diagram

DecisionAnalysis 8
Illustration of a Decision Tree
1. A decision point is shown by a rectangle
2. Alternatives available at a decision point are
shown as decision branches (DB).
DB 3. At the end of each DB, there
can be two or more chance
CB events shown by a node
20% chance branches (CB).
55%
Decision Chance events must be mutually
point 25%
exclusive and exhaustive (total
probability = 1).
20% + 55% + 25% = 100% = 1 as a
ratio
4. At the end of each branch is an endpoint shown as a triangle
where a payoff will be identified. 9
Example 1
• A bus operator has a choice of entering into a maintenances
contract for a new bus he has acquired that will cost him
$2,500. With the contract in operation, there is a 0.1
probability of a break down over the contract period but
without the contract, the probability is 0.3. The operator
reckons that if he can avoid a breakdown, his profits will be
$20,000 but this will drop to $10,000 in the event of such a
breakdown.
Required:
a) Construct a Decision Tree for this scenario
b) Should he enter into the contract?
 So
EMV = (1,000 + 18,000) – lu
Break down ti
2,500 on
Profit = 10,000 x 0.1 = $1000
= $16,500
0.1

No Break down
0.9 Profit = 20,000 x 0.9 = $18,000
a ct
tr
o n 500
C ,
$2 Break down
No Profit = 10,000 x 0.3 = $3,000
co 0.3
$0

nt
ra
ct
0.7
No Break down
Profit = 20,000 x 0.7 = $14,000

EMV = 3,000 + 14,000

= $17,000 Your decision?: No contract
Example 2 - Thompson Lumber Co.
1. Decision: Whether or not to make and sell
storage sheds
2. Alternatives:
• Build a large plant
• Build a small plant
• Do nothing
3. Outcomes: Demand for sheds will be high,
moderate, or low
 4. Payoffs Table
Outcomes (Demand)

High Moderate Low

Alternatives
Large plant 200,000 100,000 -120,000

Small plant 90,000 50,000 -20,000

No plant 0 0 0

Probability 0.3 0.5 0.2

5. Apply a decision modeling method

Decision Tree for Thompson Lumber
 Folding Back a Decision Tree

• For identifying the best decision in the tree

• Work from right to left
• Calculate the expected payoff at each
outcome node
• Choose the best alternative at each decision
node (based on expected payoff)
 Thompson Lumber Tree with EMV’s

Decision: Build a large plant because it yields more profit

Example 3:

Jenny Lind is a writer of romance novels. A movie

company and a TV network both want exclusive
rights to one of her more popular works. If she signs
with the network, she will receive a single lump sum,
but if she signs with the movie company, the amount
she will receive depends on the market response to
her movie. What should she do?
 Payouts and Probabilities
• Movie company Payouts
– Small box office - $200,000
– Medium box office - $1,000,000
– Large box office - $3,000,000

• TV Network Payout
– Flat rate - $900,000

• Probabilities
– P(Small Box Office) = 0.3
– P(Medium Box Office) = 0.6
– P(Large Box Office) = 0.1
Solution – Decision Tree
Small Box Office
$200,000

Sign with Movie Co. Medium Box Office

$1,000,000

Large Box Office

$3,000,000

Small Box Office

$900,000

Sign with TV Network Medium Box Office

$900,000

Large Box Office

$900,000
 Jenny Lind Decision Tree

Small Box Office

ER 0.3 $200,000
?
Sign with Movie Co. 0.6 Medium Box Office
$1,000,000
ER 0.1
? Large Box Office
$3,000,000

Small Box Office

ER 0.3 $900,000
?
Sign with TV Network 0.6 Medium Box Office
$900,000
0.1
Large Box Office
$900,000
 Jenny Lind Decision Tree - Solved
Small Box Office
$200,000
ER 0.3
960,000
Sign with Movie Co. 0.6 Medium Box Office $1,000,000

0.1
ER Large Box Office
$3,000,000
960,000

Small Box Office $900,000

ER 0.3
900,000
Sign with TV Network 0.6 Medium Box Office
$900,000

0.1
Large Box Office $900,000

Decision: Sign with Movie Company

 Something to Remember
Jenny’s decision is only going to be made one time,
and she will earn either $200,000, $1,000,000 or
$3,000,000 if she signs the movie contract, not the
calculated EMV of $960,000!!

Nevertheless, this amount is useful for decision-

making, as it will maximize Jenny’s expected returns in
the long run if she continues to use this approach.
 Example 4
• Suppose your organisation is using a legacy software. Some influential
stakeholders believe that by upgrading this software your organisation
can save millions while others feel that staying with the legacy
software is the safest option. The stakeholders supporting upgrade of
the software further split into two factions; those supporting buying a
new software and those that support building the new software in-
house.
• Building a new software is associated with a cost of $500,000
• Buying a new software is associated with a cost of $750,000
• Staying with the legacy software is associated with a maintenance cost
of $100,000.
• The impact if the buying or building of a new software is unsuccessful
is 2M. The probability that buying a new software is unsuccessful is
0.05 and that for building a new software being unsuccessful is 0.4.
Staying with the software will lead to only one impact which is 2M
since the software is currently meting the company needs. Advise the
company using a Decision Tree.
EMV = 750,000 + (0.05 x So
2million) Successful deployment lu
ti
= $850,000 on
Impact = $0
00 .95
0.9
,0
750 0.05 Unsuccessful deployment
y,$
Bu Impact = $2million

Buil
d, $ Successful deployment
a de 5 00
,000
pgr Impact = $0
U 0.6
St 0.4 Unsuccessful deployment
ay
le Impact = $2million
ga
cy
$100,
000

EMV = 100,000 + Impact = $2million

2million
= $2,100,000
Your decision?:
EMV = 500,000 + (0.4 x
2million) Upgrade by Buying
= $1,300,000
Solved
• Building a New Software: $2,000,000 x 0.4 = $800,000

• Buying a New Software: $2,000,000 x 0.05 = $100,000

• Staying with the legacy: $2,000,000 x 1 = 2,000,000

Adding the setup cost to each EMV

• Building a new software: 800,000 + 500,000 = $1,300,000
• Buying a new software: 100,000 + 750,000 = $850,000
• Staying with the legacy: 2,000,000 + 100,000 = $2,100,000

Decision: Buying new software is the most cost efficient even

though its initial set up cost is highest.
 Example 5
You bought 500 units of X @$10 each.
A dealer has offered to buy these from you @$14 each ( you can
make $4/unit profit).
You can sell these yourself for $16 each ($6/unit profit) but the
demand is uncertain. The demand distribution is shown in the
table.

Demand: X 300 400 500 600

Pr(X) 0.30 0.45 0.20 0.05

Obviously, if demand exceeds 500, you will sell all 500. On the
other hand, if demand is under 500, you will have leftover units.
These leftover items can disposed off for $7 each ($3 loss, the
dealer will no longer buy these leftover units from you).
What’s your decision?
26
 Example 5...
Suppose you have 500 units of X in

Demand: X 300 400 500 600 stock, purchased for $10 each.

Pr(X) 0.30 0.45 0.20 0.05 Dealer sales price: $14, self sale
price: $16 with salvage value: $7.
Start with the tree having 2 branches
Dealer
Sale (DB) at the decision point.
3 0%
00, 45% There are no chance events in the
3 400,
Self sale
500, 20% dealer sale branch,
600
, 5% For the self sale, there are 4 mutually
exclusive possibilities.
 Example 5...
Suppose you have 500 units of X in
Demand: X 300 400 500 600 stock, purchased for $10 each.
Pr(X) 0.30 0.45 0.20 0.05 Dealer sales price: $14, self sale
price: $16 with salvage value: $7.
EMV = 2000 Payoff = 500 x 4 = 2000

S ale Payoff = (300 x 6) – (200 x 3) = 1200

l e r
a 0%
De 3
0, %
3 00, 45
0 Payoff = (400 x 6) – (100 x 3) = 2100
4
Se
lf
sa

500, 20% Payoff = 500 x 6 = 3000

le

600
, 5%
Payoff = 500 x 6 = 3000
EMV = 0.3*1200 + 0.45*2100
+ 0.2* 3000 + 0.05*3000 =
2055
Your decision?: Self Sale
 Risk Profile
Risk profile is the probability distribution for
the payoff associated with a particular action.

300 Payoff = 1200

30%
Self Sale
45% 400
Payoff = 2100
20%
500
5%

Payoff = 3000
60
0

Payoff = 3000

The risk profile shows all the possible economic outcomes and
provides the probability of each: it is a probability distribution for
the principal output of the model.29
Example. 6
Mary is a manager of a gadget factory. Her factory has been
quite successful the past three years. She is wondering
whether or not it is a good idea to expand her factory this
year. The cost to expand her factory is $1.5M. If she does
nothing and the economy stays good and people continue to
buy lots of gadgets she expects $3M in revenue; while only
$1M if the economy is bad.
If she expands the factory, she expects to receive $6M if
economy is good and $2M if economy is bad.
She also assumes that there is a 40% chance of a good
economy and a 60% chance of a bad economy.
(a) Draw a Decision Tree showing these choices.
 Solution

40 % Chance of a Good
0.4 Economy Profit = $6M
Expand Factory
0.6
60% Chance Bad
(Cost = $1.5 M) Economy Profit = $2M

Good Economy (40%)

0.4
Profit = $3M
Don’t Expand
Factory Cost = 0.6 Bad Economy (60%)
$0
Profit = $1M
EMVExpand = (0.4(6) + 0.6(2)) – 1.5 = $2.1M

EMVNo Expand = 0.4(3) + 0.6(1) = $1.8M

$2.1 > 1.8, therefore you should expand the factory

 Practice Question 7:
A glass factory specializing in crystal is experiencing a substantial
backlog, and the firm's management is considering three courses
of action:
A) Arrange for subcontracting
B) Construct new facilities
C) Do nothing (no change)
The correct choice depends largely upon demand, which may be
low, medium, or high. By consensus, management estimates the
respective demand probabilities as 0.1, 0.5, and 0.4.
Given the payoffs on the next page, manually create and solve
this problem using a decision tree.
 A Glass Factory: The Payoff Table

The management estimates the profits when choosing

from the three alternatives (A, B, and C) under the
differing probable levels of demand. These profits, in
millions of dollars are presented in the table below:

0.1 0.5 0.4

Low Medium High
A 10 50 90
B -120 25 200
C 20 40 60
 EMV = 1M + 25M +
Payoff = 10millin x 0.1 = $1M
36M Low
1)
= $62M (0.
e dium Payoff = 50million x 0.5 = $25M
0. 5) M
(
0 . 4 ) High Payoff = 90million x 0.4 =$36M
(

act . 1 ) Low Payoff = -120million x 0.1 = -$12

tr (0
c on
b dium
Su (0.5) Me Payoff = 25million x 0.5 =$12.5M
ew facililittyy
New (0.4) High
No Payoff = 200million x 0.4 = $80M
ch
an
ge
(0.1) Low
Payoff = 20million x 0.1 = $2M
(0.5) Me
dium
(0.4 Payoff = 40million x 0.5 = $20M
) H ig
EMV = 2M + 20M + h
24M Payoff = 60million x 0.4 = $24M
= $46M
EMV = -12M + 12.5M + Your decision?:
80M
= $80.5M New facilities
 Usefulness of Decision Tree approach
• A decision tree is a visual representation of a decision
situation (and hence aids communication).
• It clearly brings out the impact assumption and calculation

• It allows the decision maker to visualize assumptions and the

alternatives in a graphic form which is usually much easier to
understand than the more abstract analytical forms
• A decision tree allows for forward and backward calculation
paths to happen and hence the choice of the correct decision
to take is made automatically.
 Exercise Question 1

A small company has developed a new product for the electronic

industry. The company believes that an advertising campaign costing
$2000 would give the product a 70 per cent chance of success. It
estimates that the product, with this advertising support, would
provide a return of $11,000 if successful and a return of $2000 if not
successful. Past experience suggests that without advertising support,
a new product of this kind would have a 50 per cent chance of
success giving a return of $10,000 if successful and a return of $1,500
if not successful.
Required:
Construct a decision tree and write a report advising the company on
its best course of action
Exercise Question 2: A Gambling Referendum
A gambling referendum has been placed on the ballot in River
City. ABC Entertainment is considering whether or not to
submit a bid to manage the new gambling business. ABC
must decide whether or not to hire a market research firm
(Gallup). If Gallup is hired, they will obtain a prediction that
the referendum will either pass or fail. Following this, they
will learn if their bid is a winning one. Set up the decision
tree with all event nodes and decision nodes, and label all
branches. Do not include any probabilities or payoffs.
 Exercise Question 3
Riham Cola Ltd. wants to move into a new sales region and must
determine which of the two plants to build. It can build a large plant that
costs $4million or a small plant that costs $2million. The company
estimates that the probability of the economy to be booming, normal or
in recession is 30%, 40% and 30% respectively. The company also
estimated the present value in (millions of dollars) of the cash flows for
each type of plant under each state of economy to be as indicated in the
payoff matrix below:
Type of Plant Construct a decision tree
State of economy Large Plant Small Plant
for the firm to show
Boom $10M $4M which of the plants the
Normal $6M $3M
Recession $2M $2M
company should build.
Exercise Question 4
Basic Business has a new product, and two options exist. It can either test
market the product or abandon the product. If the company test market
the product, the cost will be $50,000 and the market response could be
favaourable or unfavorable with probabilities of 0.7 and 0.3 respectively.

If the response is favorable, the outcome can be high sales, medium sales
or low sales with probabilities of 0.15, 0.60 and 0.25 respectively. The
respective net gains or losses for the above outcomes are $450,000,
$150,000 and -$100,000. If the result of the test marketing is not
favourable, the company can abandon the product and abandoning the
product at any stage, it results into a net gain of $30,000.
 Required

a) Draw a decision tree

b) Include the figures for costs, loss or profit on the

appropriate branches of the tree

c) Give the final decision on whether to market the

product or to abandon
 END
THANK YOU