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Decision Trees - 3

Decision trees are models that map out alternative decisions and their potential consequences, taking into account the probabilities of various outcomes occurring and the financial impacts of each decision. They clarify possible actions, incorporate financial data, and require managers to consider risk. However, probabilities may be underestimated, qualitative factors are ignored, and they do not account for changing business dynamics over time. Other influences on decisions include company objectives, ethics, risk tolerance, resources, and external environment. Constructing a decision tree involves adding decision points, costs, outcomes, financial impacts, and probabilities to calculate the expected value and identify the optimal choice.

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36 views4 pages

Decision Trees - 3

Decision trees are models that map out alternative decisions and their potential consequences, taking into account the probabilities of various outcomes occurring and the financial impacts of each decision. They clarify possible actions, incorporate financial data, and require managers to consider risk. However, probabilities may be underestimated, qualitative factors are ignored, and they do not account for changing business dynamics over time. Other influences on decisions include company objectives, ethics, risk tolerance, resources, and external environment. Constructing a decision tree involves adding decision points, costs, outcomes, financial impacts, and probabilities to calculate the expected value and identify the optimal choice.

Uploaded by

Sharen Hari
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Decision Tress 1

Decision trees are a method of tracing alternative outcomes from a range of business decisions,
options or projects. The purpose of decisions tree analysis is to place an expected financial or
different decisions based on the probability of the event occurring.

Decision trees
This is a model that represent the likely outcomes for a business of a number of courses of action
showing the financial consequences of each.

Benefits
• Clarifies possible courses of action
• Adds financial data to decisions
• Makes managers account for risk

Drawbacks
• Probabilities are often underestimated.
• Does not consider qualitative information
• Does not take into account dynamic nature of business

Influences on decision-making
There are other factors that may play a part in shaping management decisions. There include:

• The objectives and mission of the business


• Ethics – using a ‘moral compasses’ to guide decisions
• The level of risk involved – some managers and businesses are more risk averse than others.
• The external environment including competition – most decision-making models do not take
into account these factors which are constantly changing.
• Resource constrains – a business can only make decisions if it has the resources available
(labour, capital, knowledge) and this is where opportunity cost comes in.
Decision tree example
The example shows a business with two investment decisions ( or do nothing ). The expected value (
EV) is highest on the marketing campaign and therefore the option the business should take.
Constructing a decision trees
The five stages below will help you to construct a compete decision tree, which can then be used to
make investment decisions.

1 – Add information to the decisions tree, such as;

• Decisions
• Costs
• Outcomes
• Financial benefits
• Probability
2 – Multiply each financial benefit by its probability for each outcome and add them
together to get the expected value.
3- If there is an initial cost ( £1 m to train staff), subtract this to get the net gains of the
decisions.
4- Repeat this progress for each decision.
5 – Cross through the operations not taken.
High impact

(Outcome)
£ 5 million
Staff training £1 million
Financial
(Decision) Cost 0.5 benefits
B Probability

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