Decision trees

• Managerial decisions involving risk are

often made in stages, with subsequent
decisions and events depending on the
outcome of earlier decisions and events.
• A decision tree shows the sequence of
possible managerial decisions and their
expected outcomes under each set of
circumstances or state of nature.
02/06/23 Dr Paul Netalisile Malunda 1
 Decision trees
• These are probability trees adapted so
that they can be used for making
business decisions.
• A decision tree is a schematic model of
the sequence of steps in a problem and
conditions and consequences of each
step.

02/06/23 Dr Paul Netalisile Malunda 2

 Decision trees
• In solving decision tree problems, we
work from the end of the tree backwards
to the start of the tree.
• As we work backwards, we calculate the
expected values at each step. This
process solves the decision problem.

02/06/23 Dr Paul Netalisile Malunda 3

 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).

02/06/23 Dr Paul Netalisile Malunda 4

 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
02/06/23 Dr Paul Netalisile Malunda 5
 Example
• A bus operator has a choice of entering
into a maintenance contract for a new
bus he has acquired that will cost him $
2,500 with the contract in operation
there is only a 0.1 probability of a break
down over the contract period but
without it the probability is 0.3.

02/06/23 Dr Paul Netalisile Malunda 6

 Example
• The operator reckons that if he can avoid
a break down his profit will be $ 20,000
but this will drop to $ 10,000 in the event
of such a breakdown. Should he enter
into the contract?

02/06/23 Dr Paul Netalisile Malunda 7

 Example
• If he enters the maintenance contract
His expected profit will be; 
(0.9x 20,000) + (0.1x10, 000) –2,500 
= $16500
• If he doesn’t;
His profit is expected to be;
(0.7x20, 000) + (0.3x10, 000)
= $ 17,000.
• Decision: no entering contract.
02/06/23 Dr Paul Netalisile Malunda 8
 Example 2
• Suppose your organisation is using a legacy
software and 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
the upgrade of the software are further split
into two factions;

02/06/23 Dr Paul Netalisile Malunda 9

 Example 2 cont..
Those supporting buying the new software
and those that support building the new
software – in house

Building the new software is associated with a

cost of $500,000
Buying the new software is associated with a
cost of $ 750,000

02/06/23 Dr Paul Netalisile Malunda 10

 Example 2 cont…
• Staying with the legacy software is associated
with a maintenance cost of $100,000
• The impact if the buying of the new software
or building the new software is unsuccessful is
$2m. The probability that buying a new
software will be unsuccessful is 0.05 and the
probability of building a new software being
unsuccessful is 0.4.

02/06/23 Dr Paul Netalisile Malunda 11

 Example 2 cont…
• The stay with legacy software option will
only lead to one impact which is $2m
because the legacy software is not
currently meeting the needs of the
company.

02/06/23 Dr Paul Netalisile Malunda 12

 From the Decision tree:
• The Expected Monetary Value associated with
each risk is calculated by multiplying the
probability of the risk with the impact
Building the new software: $2,000,000 X 0.4
= $ 800,000
Buying the new software: $ 2,000,000 X 0.05
= 100,000

02/06/23 Dr Paul Netalisile Malunda 13

 From the Decision tree attached:
Staying with the legacy: $2,000,000 X 1
= 2,000,000
Adding the set up costs to each Expected
Monetary Value
Build the new software: $500,000 + $800,000
= $1,300,000
Buy the new software $750,000 + $ 100,000
= $850,000

02/06/23 Dr Paul Netalisile Malunda 14

 From the Decision tree attached:
Staying with the legacy software:
= $100,000 + $2,000,000
= $2,100,000
Decision:
Buying the new software is actually the most
cost efficient option even though its initial set
up cost is highest

02/06/23 Dr Paul Netalisile Malunda 15

 Example
Draru Limited 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 estimated that the
economy will be booming, normal, or in
recession is 30%, 40% and 30%, respectively.
The company also estimated the present
value (millions of dollars) of net cash flows for
02/06/23 Dr Paul Netalisile Malunda 16
 Example continues
each type of plant under each state of
economy to be as indicated in the following
payoff matrix. Construct a decision tree for
the firm to show which of the plants the
economy should build. Assume the company
is risk neutral

02/06/23 Dr Paul Netalisile Malunda 17

 Example cont…

State economy Large plant Small plant

/type of plant
Boom $10m $4m
Normal $6m $3m
recession $2m $2m

02/06/23 Dr Paul Netalisile Malunda 18

 Usefulness of Decision tree approach
- It clearly brings out the impact
assumption and calculation
- It allows a decision maker to visualize
assumptions and alternatives in graphic
form which is usually much easier to
understand than the more abstract
analytical form

02/06/23 Dr Paul Netalisile Malunda 19