Scribd
Upload
31 views

Business Strategy 1C - Decision Tree

Uploaded by

snatasya113085
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
31 views

Business Strategy 1C - Decision Tree

Uploaded by

snatasya113085
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 13

Strategic Choice – part

2
DECISION TREE
Decision Tree
Decision tree: a diagram that sets out the options connected with a
decision and the outcomes and economic returns that may result.
This technique is based on a diagram that is drawn to represent four main features of a
business decision:
a) All of the options open to a manager
b) The different possible outcomes resulting from these options
c) The chances of these outcomes occurring
d) The economic returns from these outcomes.
By comparing the likely financial results from each option, the manager can minimize the risks
involved.
Decision trees – how they are constructed
The tree is a diagram, which has the following
features:
a) It is constructed from left to right.
b) Each branch of the tree represents an option
together with a range of consequences or
outcomes and the chances of this occurring.
c) Decision points are denoted by a square – these
are decision nodes.
d) A circle shows that a range of outcomes may
result from a decision – a chance node.
e) Probabilities are shown alongside each of these
possible outcomes. These probabilities are the
numerical values of an event occurring – they
measure the chance of an outcome occurring.
f) The economic returns are the expected financial
gains or losses of a particular outcome.
Expected value: the likely financial result of an
outcome obtained by multiplying the probability of
an event occurring by the forecast economic return if
Decision it does occur.

trees – Therefore, the expected value of tossing a coin and


winning $5 if it comes down heads is 0.5 × $5 = $2.50.
working out In effect, the average return, if you repeated this a
number of times, would be to win $2.50.
the expected The purpose of a decision tree is to show the option
that gives the most beneficial expected value.
values
Example 1:
The manager of an events-organizing business has to decide between holding a fundraising
auction indoors or outdoors. The financial success of the event depends not only on the weather
but also on the decision to hold it indoors or outdoors. Table 39.1 shows the expected net
financial returns or ‘economic returns’ from the event for each of these different circumstances.
From past weather records for August, there is a 60% chance of fine weather and a 40% chance
of it being poor. The indoor event will cost $2,000 to arrange and the outdoor event will cost
$3,000.
Example 1
Example 1
Example 1
a) The expected value at node 1 is $5,800.
b) The expected value at node 2 is $7,600.
• Subtract the cost of holding the event either indoors or outdoors.
a) Indoors = $5,800 – $2,000 = $3,800
b) Outdoors = $7,600 – $3,000 = $4,600.
Therefore, the events manager would be advised to hold the event outdoors as, on average, this will give the
highest expected value. The other option is ‘blocked off ’ with a double line in the figure to indicate that this
decision will not be taken.
Example 2 :
A construction company’s options over a derelict building that it has owned for some time, is
shown in Figure 39.5.
There are two options facing the business initially:
1 The building could either be sold now for $1 million or improved and updated at a cost of $0.5
million. After renovation, the building could be sold as one house.
2 However, after renovation, another option is to split the building into three flats, which will
cost a further $0.25 million.
3. The chances of the interest rate being high during the sale period of a house/flat is 60% and
the interest rate being low is 40%.
Advantages of Decision Tree
1. They force the decision-maker to consider all of the options and variables related to a decision.
2. They put these on an easy-to-follow diagram, which allows for numerical considerations of risk
and economic returns to be included.
3. The approach encourages logical thinking and discussion among managers.
Decision trees – an evaluation
a) The primary limitation concerns the accuracy of the data used.
b) The probabilities of events occurring may be based on past data, but circumstances may
change.
c) Decision tree does not consider the qualitative factors – but their impact on the decision is
equally important. For e.g., the impact on the environment, the attitude of the workforce,
and the approach to the risk taken by the managers and owners of the business.
d) The expected values are average returns, assuming that the outcomes occur more than
once. With any single, one-of decision, the average will not, in fact, be the final result.
e) Decision trees allow a quantitative consideration of future risks to be made – they do not
eliminate those risks.

You might also like