Decision trees

Question 1

Define DECISION TREES

Answer 1

Decision trees are mathematical models used to help managers make decisions. It uses estimated returns and probabilities to calculate likely outcomes, helping to decide whether the net gain from a decision is worthwhile.

Question 2

Define EXPECTED VALUE

Answer 2

An expected value is the anticipated value of an investment. Calculated by multiplying each of the possible outcomes by the probability of that outcome happening and summing all those values.

Question 3

What are the advantages of decision trees?

Answer 3

• Forces managers to carefully consider the impacts, outcomes and options involved in a decision using methodical methods.
• The inclusion of probability may make them more useful than investment appraisal techniques.
• Helps businesses see the best and worst case scenario which is helpful if the decision could threaten a firm’s survival.

Question 4

What are the disadvantages of decision trees?

Answer 4

• Only as useful as the data within them - how accurate are the probabilities?
• Risk of unreliable data with one off or first time decisions
• Risk of management bias
• Only focuses on quantitative data
• Non-dynamic and may be out of date before a decision can be reached.

Question 5

How do you construct a decision tree?

Answer 5

1. Draw a square decision node to show that a decision needs to be made.
2. Draw lines coming out of it to indicate different options. Write the name of the option above the line and the costs of it below.
3. Draw circular chance nodes to indicate that the outcome is not certain.
4. Draw lines coming out of each chance node to show the different possible outcomes and write the probability that each happens under the line.
5. Write the estimated financial return for each option.
6. Work out the expected values (probability x return) and add them up for that option. Minus the cost to calculate net gain for that option.

Question 6

Define NET GAIN

Answer 6

Net gain is the value that will be gained by taking a decision. It is calculated by deducting the cost of the investment from its expected value.