Unit 1 extra BM

tools (HL/SL)
DECISION
TREES
Decision Trees

No technique can eliminate the risk involved in taking decisions, but managers
help
can themselves greatly if they adopt a logical approach to decision-making.
method
One of considering all the options available and the chance of them
occurring is known as decision trees.

This device is a diagram that is drawn to represent three main features

of a decision:

◦All the options open to a manager.

◦The different possible outcomes resulting from these options.
◦The chances of these outcomes occurring.

In brief, a decision tree may be defined as a diagram that sets out the
options
connected with a decision and the outcomes that my result from
‘chance’, following these options. The manager can minimise the risk
involved.
A Simple Decision Expected Values
Tree
Outcomes/Chance
Nodes Probability/ Chance

Decision Profit or Loss

Nodes/Point Success
$15 Million
0.2

Launch New Campaign

B

Failure
A -$2 Million
0.8
Success $7 Million 0.4

Retain old Campaign C

Failure -$1 Million

0.6

A simple decision tree based on a decision whether to retain and existing advertising
campaign or begin a new one
 Constructing a Decision
◦
Tree
Constructed from left to right.

◦ Each branch of the tree represents an option together with a range of

consequences of outcomes and the chances of these occurring.

◦ Decision points are denoted by a square – these are decision nodes.

◦ A circle shows that a range of outcomes may occur – a chance node.

◦ Probabilities are shown alongside each of these possible outcomes. These

probabilities measure the chance of an outcome occurring.

◦ They pay-offs are the expected financial gains or losses of a particular outcome.
Features of a decision
tree
1. Decision Point: Points where decisions have to be made. They
are represented by squares.

2. Outcomes: Points where there are different possible outcomes in

a decision tree are represented by circles called chance nodes.

3. Probability or Chance: The likelihood of possible outcomes

happening is represented by probabilities.

4. Expected Values: This is the financial outcome of a decision, which

is based on the predicted profit and loss of an outcome and the
probability of that outcome occurring.
 Expected Value
Net Outcome value x Probability

Chance Outcome 1
Node Probability (Decimal) Outcome 1 value x Probability
+
Option
B Outcome 2 value x Probability
=
Option B Expected Value
Outcome 2
Probability (Decimal)
Decision
Node
A
Outcome 1
Probability (Decimal)
Outcome 1 value x Probability
Option +
C Outcome 2 value x Probability
=
Rejected Decision Outcome 2 Option C Expected Value
(Unwanted Chance
outcome branch) Node Probability (Decimal)
A Simple Decision Expected Values
Tree
Outcomes/Chance
Nodes Probability/ Chance

Decision Profit or Loss

Nodes/Point Success
$15 Million
0.2

Launch New Campaign Expected Value = Probability of an event

B occurring * Expected Results
Calculating the expected value of the new
campaign
Expected Value = 0.2 * $15m + 0.8 * (-$2m)
Failure =$ 1.4m
A -$2 Million
0.8
Success $7 Million 0.4

Calculating the expected value of retaining

Retain old Campaign C current campaign
Expected Value = 0.4 * $7m + 0.6* (-$1m)
= $2.2m
Failure -$1 Million
0.6

A simple decision tree based on a decision whether to retain and existing advertising
campaign or begin a new one
 Calculating the Expected
Value Value = Probability of an event occurring * Expected Results
Expected

Calculating the expected value of the new

campaign Expected Value = 0.2 * $15m + 0.8

* (-$2m)
(Probability) (Expected Profit)+ (Probability) (Expected Profit)

=$3m - $1.6m
=$ 1.4m

Calculating the expected value of retaining current

campaign Expected Value = 0.4 * $7m + 0.6* (-
$1m)
= $2.28m – 0.6m
= $2.2m
 Questio
n
A friend has given you a sum of money for your 18th birthday which you want
to invest in shares. A local independent financial advisor suggests that you
ought to consider three companies:

◦ Techy Co- A high tech manufacturer.

◦ Risky Co- A new manufacturer, selling a brand new product which is predicted to
be all ranges over the next two or three years.

◦ Large Co – A multinational conglomerate which sells to a wide range of

industries.
(Question continued over
page…)
Question
Continued
Chance of Success Chance of Failure

Techy-Company 0.5 0.5

Risky - Company 0.3 0.7
Large Company 0.8 0.2
Pay-off if Successful Pay-off if Failure

Techy-Company $2,000 $800

Risky - Company $3,000 $500
Large Company $1,200 $900

Required: Calculate the expected value for each of the

three companies and decide on the best investment
Case example (including
costs)
A business is deciding whether or not to launch a new product. It could do some
market research, costing $12,000 which would mean the chance of a successful
launch would be estimated at 70%. Without market research the chance of a
successful launch would be only 50%. A successful launch would earn profit of $
60,000 for the business, but if it failed, only $20,000 would be earned.
This information is summarised below

With market Without Market

research Research
Successful Launch ($60,000) 70% 50%
Failed Launch ($20,000) 30% 50%

From the information, prepare a diagram of

expected values and discuss the best course of
action for the business.
ANSWER

Failure

Expected Values
Node 1:( 60,000*0.7) + (20,000*0.3) =$48,000
Node 2: (60,000*0.5) + (20,000*0.5) = $40,000
Question? Which option do you
recommend? Justify your answer.
 Problems of using decision
trees
It is purely quantitative technique, which is designed to allow for probability and
pay- off. There is no allowance for external issues which may be relevant to the
decision being made.

The probabilities are extremely difficult to predict accurately, given their nature.

The forecast pay-offs are assumed to be correct, which may not be the case
in reality. If both probability and forecast pay-offs are incorrect then the
decision becomes as good as the information which is issued.

There are no in-between value for probability, that is, the pay-off can be one of
three options – successful, moderate, poor. All the probabilities must add up to
one, but in reality there is a wider range of answers, each with an associated
probability.
Conclusion

Given the problems and assumptions, what is the point of using

decision trees in the first place?

They provide a starting point in terms of allocating probabilities

and pay-offs to different decisions.

They allow all potential decisions to be viewed simultaneously.

They can therefore act as an aid to decision making and must be

used in conjunction with other factors which affect the decision.
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