LESSON PLAN:

At the end of this topic students should be

able to:
 Understand the significance of decision tree
as a management tool.
 Use decision tree in decision-making
analysis
SOME DEFINITIONS:

A management tool for choosing between
several courses of inter-related action


Predictive models, used to graphically
organize information about possible
options, consequences and end value.
SOME DEFINITIONS :

Tree-like diagram where you can lay out
options and investigate the possible
outcomes (probability, costs, risks, reward,
utility) of choosing those options.


balanced picture of the risks and rewards
associated with each possible course of
action.
SOME DEFINITIONS:

Tools used for deciding between several courses of
action. They create a visual representation of the
various risks, rewards and potential values of each
option.


Decision trees are commonly used in operations
research, specifically in decision analysis, to help
identify a strategy most likely to reach a goal.
 DECISION TREE NODES:
A Decision Tree consists of 3 types of nodes:-
1. Decision nodes: commonly represented by squares- for
possible options
2. Chance nodes: represented by circles- for uncertain
outcomes
3. End nodes: represented by triangles-for the value of
each option and outcome
 RMxxx
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STEPS IN USING A TREE DIAGRAM:
1.
Draw a small square towards the left of a piece of
paper to represent the decisions to be made
2.
draw out lines towards the right for each possible
option/solution, and write that solution along the
line;
3.
At the end of each line, consider the results:
i. certain result-draw a line and put a value for
that result
ii. Uncertain result - draw a small circle; draw out
lines for each possible outcome
STEPS IN DRAWING A TREE DIAGRAM:
iii. If the result is another decision that you need
to make, draw another square.
4. put a score/cash value and the probability of each
outcome
5.
Draw a payoff table/matrix
6. Calculate the value of each possible option and
compare to make the decision
 SHOW AN EXAMPLE OF A DECISION TREE, YOU
MAY USE YOUR OWN EXPERIENCE WHERE YOU
HAVE TO TAKE A CERTAIN IMPORTANT
DECISION IN YOUR LIFE.
EXAMPLE 1:
An investor has to decide between investing in option
A or B. The expected profit of option A is estimated at
RM500K if economy is good or RM100K if economy is
poor. The profit for option B is expected at RM300K if
the economy turns out to be good or RM200K if it
turns out to be poor. The chances of good economy
is 60%.
Make a decision tree analysis to help the investor
choose the best option.
product economy chances payoffs

A Good 0.6 500K

Poor 0.4 100K

B Good 0.6 300K
poor 0.4 200K
DECISION TECHNIQUES:
I. technique under uncertainty
a) Maximax rule- for optimistic investors
- Choose highest payoffs among highest
b) minimax rule- for play safe investor
- Choose highest payoffs among lowest
c) Minimum regret approach- for investor who tries to
minimise opportunity loss
- Choose lowest opportunity loss
Maximax and minimax rule:
product economy chances payoffs

A Good 0.6 500K –highest

among highest
Poor 0.4 100K
B Good 0.6 300K
poor 0.4 200K-highest
among lowest
MINIMUM REGRET RULE

product economy chances payoffs OPPORTUNITY LOSS MIN.

REGRET
A Good 0.6 500K 500-500=0K

Poor 0.4 100K 100-200=100K 0+100

=100K

B Good 0.6 300K 300-500=200K

poor 0.4 200K 200-200=0K 200+0

=200k
TECHNIQUE UNDER UNCERTAINTY:
1.Maximax: highest payoffs within good economy:
product A (500K) vs product B (300K)
=product A (500)

2.Minimax: highest payoffs within poor economy :

product B (200K) vs product A (100K)
=product B (200K)

3.minimum regret: product A(0+100) vs B (200 +0)

=product A (100K)
DECISION TECHNIQUES:
II. Technique under risk
- Takes into account of probability
a) Expected monetary value
- choose highest EMV
b) Expected opportunity loss
- choose lowest EOL
PRODUCT ECONOMY CHANCES PAYOFFS VALUE EMV

A GOOD 0.6 500K 0.6X500

A GOOD 0.6 500K 0.6X500
=300K
=300K

POOR 0.4 100K 0.4X100 340,000

POOR 0.4 100K 0.4X100 340,000
=40K
=40K

B GOOD 0.6 300K 0.6X300

B GOOD 0.6 300K 0.6X300
=180K
=180K
POOR 0.4 200K 0.4X200 260,000
POOR 0.4 200K =80K
0.4X200 260,000
=80K
PRODUCT ECONOMY CHANCES PAYOFFS OPPORTUNITY VALUE EOL
LOSS

A GOOD 0.6 500K 500- 0.6X0

500 =0
=0K
POOR 0.4 100K 100- 0.4X100 40K
200 =40K
=100K
B GOOD 0.6 300K 300- 0.6X200
500 =120K
=200K

POOR 0.4 200K 200- 0.4X0 120K

200 =0
=0K
EXERCISE 1:
AN investor planned to invest a sum of money and he has to
choose between investing in property or in bonds. However,
return to each option will be influenced by the future
economic growth which may be solid, stagnant or slowing.
The expected rate of return of each option as per each
economic condition are as follows:
Economic growth Rate of return (%)
Property Bonds
Solid 11 8
Stagnant 7 7
Slowing 5 6

The probability of the economic growth to be solid is 40%,

stagnant is 40% and slowing down is 20%.
OPTION ECONOMIC CHANCES RETURN OPP. LOST
GROWTH (%)
PROPERTY solid 0.40 11 11-11=0
stagnant 0.40 7 7-7=0
slowing 0.20 5 5-6=1
BONDS solid 0.40 8 8-11=3
stagnant 0.40 7 7-7=0
slowing 0.20 6 6-6=0
OPTION ECONOMIC CHANCE RETURN OPP. EMV EOL
GROWTH S (%)
LOST
PROPERTY solid 0.40 11 0 0.4X 11 0.4X0
stagnant 0.40 7 0 0.4X7 0.4X0
slowing 0.20 5 1 0.2X5 0.2X1
BONDS solid 0.40 8 3 0.4X8 0.4X3
stagnant 0.40 7 0 0.4X7 0.4X0
slowing 0.20 6 0 0.2X6 0.2X0
ADVANTAGES OF DT:
i. Decisions are made after careful and thorough
analyses of many factors
ii. Takes into account of future uncertainty
iii. The more info taken into account, the better the
decision
DISADVANTAGES of DT
i. difficulty to predict probability
ii. difficulty to decide on options/alternative actions
EXERCISE 2:
An investment company is considering to undertake a
commercial project which will take 2 yrs to complete. During this
period the economy may either improve or fall. The project
could be undertaken alone or on JV basis. If the economy is
good, the expected profit will be RM2M if taken alone; or
RM1.4M if it is on JV basis. If economy falls the company can
make a loss of RM1M if the project is undertaken alone; but if it
is on JV basis, the loss will be RM200K.
Using decision tree analysis:
a) Advise the company on the best option under uncertainty
situation;
b) Advise the company on the best option under risk situation if
there is 70% chances that the economy will be good;
c) Tabulate the payoffs and regret table
DECISION ANALYSIS WHEN COSTS AND
REVENUE HAVE PROBABILIES:
Example 2:
Ehsan Jaya Bhd planned to undertake a
development project. There are 2 available
alternatives but the company will be faced by
uncertain revenue and costs because of the
fluctuating scenario in the economy. The
estimated revenue and costs of the alternative
projects are as follows:
Example:2
Option A Option B
Est.revenue Probability Est.revenue Probability
RM1400M 0.4 RM1600M 0.6
RM780M 0.6 RM890M 0.4

Est. costs Probability Est. costs Probability

RM760M 0.3 RM800M 0.8
RM380M 0.7 RM400M 0.2

Advice the investor which option to choose based on the EMV

calculation.
OPTION COSTS CHANCES REVENUE CHANCES

1400 0.4
760 0.3
780 0.6

A 1400 0.4
380 0.7
780 0.6

1600 0.6
800 0.8
890 0.4
B 1600 0.6
400 0.2
890 0.4
OPTION COSTS CHANCES REVENUE CHANCES EMV NET EMV
1400 0.4 1400x0.4=
560

760 0.3
780 0.6 780x0.6= (560+468)-
468 (0.3x760)=
800

A 1400 0.4 1400x0.4=

560

380 0.7
780 0.6 780x0.6=4 (560+468)-
68 (0.7X380)=
762

Total EMVA
=1560
 COMPLETE THE CALCULATION FOR THE B
OPTION
Exercise 3:
A developer has plans to undertake either of these 2 projects: option A involving
a 30 storey office complex, or option B involving a 40-storey office and
condominium tower. He was informed that the costs and profits from these
developments will be subject to the changing scenario in the local and global
economy. The expected costs and profit of each option and their probabilities
are as follows:
Option probable cost(RM) chances Probable profit(RM) Chances
A 400M 0.2 1000M 0.3
520M 0.8 800M 0.6
500M 0.1
Option probable costs(RM) Chances Probable profit(RM) chances
B 600M 0.6 1200M 0.2
750M 0.4 850M 0.5
700M 0.3
Advise the developer.
MULTI-PERIOD DECISION ANALYSIS:
-Where a decision is followed by another decision

Example 4:
NSC is planning to invest in the rental sector within
the residential market. Now he must decide whether
to invest in a large or medium-sized house. The size
that could give him maximum profit is uncertain
because future demand for houses for rental could
only be predicted. According to market experts, 2
possibilities of demand level could occur i.e high,
and medium and the chances are 60% and 40%
respectively. The NPVs of the situation have been
calculated and they are as follows:
Example 4 (cont.)
If large house is purchased and dd for rental housing
is high, NPV is estimated at RM200K but if dd is
medium, NPV is estimated to be RM100K. For
medium-sized houses, NPV is estimated at RM140K
whether demand is high or medium. However if dd is
high, medium-sized houses could be renovated to
produce a NPV of RM190K but at an additional cost of
RM30K.
Which option should NSC invest in?
option Dd chances Payoff (NPV) Renovate/payoff
A) Build high 0.6 200K
large houses
medium 0.4 100K

B) Build high 0.6 140K 190K-30K=160K;

medium-
sized houses
medium 0.4 140K
 EXERCISE 4:
 Zaid Property Sdn Bhd is planning a construction of
an industrial park. The company must decide now
whether to build a small, medium or large-sized
park. The choice of size is uncertain because future
demand could only be estimated. According to a
feasibility study recently carried out by a
consultant, the following level of demand could
occur: 25% chances of high level of demand, 55%
chances of medium level of demand, 20% chances
of low level of demand. In the board meeting, the
consultant has suggested the followings:
EXERCISE 4 (cont.):
a) If a large-sized park is built and demand is high, the
NPV generated is estimated at RM180M. However if
demand is medium the NPV will be RM100M only. If
demand is low, the NPV will be a loss of RM20M.
b) A medium-sized park will have an NPV of RM120M if
demand is high or medium, and a loss of RM5.0M if
demand is low. However if demand is high, the
medium-sized industrial park could be enlarged at a
cost of RM40M to generate an additional RM80M in
NPV.
 The capacity of a small-sized industrial park will limit
the NPV to RM60M only regardless of demand. If
demand is medium however, it can be enlarged a
moderate amount at a cost of RM20M and its NPV
could then be RM110M (excluding construction cost)
EXERCISE 4 (cont.):
If demand is high, it can be enlarged greatly in size
at a cost of RM80M and NPV would then be RM170M
(excluding cost of expansion), or enlarged
moderately to increase its NPV to RM140M at an
additional cost of RM40M.
Advise your client on the best course of action to
maximise profit using the decision tree technique.