Decision Tree
A decision tree is a diagrammatic representation of a multi-decision problem, where
all possible courses of action are represented, and every possible outcome of each
course of action is shown.
Decision trees should be used where a problem involves a series of decisions being
made and several outcomes arise during the decision-making process.
The financial outcomes and probabilities are shown separately, and the decision tree
is 'rolled back' by calculating expected values and making decisions.
Step 1:
• Draw the tree from left to right, showing appropriate decisions and events /
outcomes.
• Some common symbols can be used:
• a square is used to represent a decision point (i.e. where a choice between
different courses of action must be taken.
• A circle is used to represent a chance point.
• The branches coming away from a circle will have probabilities attached to
them. All probabilities should add up to '1'.
• Label the tree and relevant cash inflows/outflows and probabilities associated
with outcomes.
Step 2:
• Evaluate the tree from right to left carrying out these two actions:
-Calculate an expected value (EV) at each outcome point.
-Choose the best option at each decision point.
Step 3:
• Recommend a course of action
Case:
A university is trying to decide whether or not to advertise a new post-graduate degree
programme.
The number of students starting the programme is dependent on economic
conditions:
If the programme is advertised and economic conditions are poor, there is a 65%
chance that the advertising will stimulate further demand and student numbers will
increase to 50.
If economic conditions are good there is a 25% chance the advertising will stimulate
further demand and numbers will increase to 25 students.
If conditions are poor it is expected that the programme will attract 40 students with or
without advertising. There is a 60% chance that economic conditions will be poor.
If economic conditions are good it is expected that the programme will attract only 20
students with or without advertising. There is a 40% chance that economic conditions
will be good.
The profit expected, before deducting the cost of advertising, at different levels of
student numbers are as follows:
Number of students Profit
15 -10000
20 15000
25 25000
30 65000
35 90000
40 115000
45 140000
50 150000
Using decision tree, suggest whether or not to advertise a new post-graduate degree
programme?
Step 1:
• Draw the tree from left to right. A square is used to represent a decision point
(i.e. whether to advertise the programme, or not advertise.).
• For both options, a circle is used to represent a chance point - a poor economic
environment, or a good economic environment.
• Label the tree and relevant cash inflows/outflows and probabilities associated
with outcomes
Step 2:
• Evaluate the tree from right to left carrying out these two actions:
• Calculate an Expected Value at each outcome point. Working from top to
bottom, we can calculate the EVs as follows:
EV (Outcome Point C) = (35% x 115,000) + (65% x 150,000) = 137,750
EV (Outcome Point D) = (75% x 15000) + (25% x 25,000) = 17,500
EV (Outcome Point B) = (60% x 115,000) + (40% x 15,000) = 75,000
EV (Outcome Point A) = (60% x 137,750) + (40% x 17,500) = 89,650
Step 3:
Choose the best option at each decision point and recommend a course of action to
management.
We should choose the option to advertise.
