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DECISION TREE - Worked Example

The document presents a decision tree example to help a property owner choose between three options: (1) A large-scale investment requiring ₹1,400,000 with a 40% chance of ₹2,500,000 return and 60% chance of ₹800,000 return, (2) A smaller ₹500,000 investment with 30% chance of ₹1,000,000 return and 70% chance of ₹500,000 return, or (3) Continuing without changes. The decision tree calculates the expected values of each option by multiplying outcomes by probabilities, then subtracting costs to find the small-scale investment has the highest expected net value of

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Ravi Jaiswal
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214 views2 pages

DECISION TREE - Worked Example

The document presents a decision tree example to help a property owner choose between three options: (1) A large-scale investment requiring ₹1,400,000 with a 40% chance of ₹2,500,000 return and 60% chance of ₹800,000 return, (2) A smaller ₹500,000 investment with 30% chance of ₹1,000,000 return and 70% chance of ₹500,000 return, or (3) Continuing without changes. The decision tree calculates the expected values of each option by multiplying outcomes by probabilities, then subtracting costs to find the small-scale investment has the highest expected net value of

Uploaded by

Ravi Jaiswal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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LBSIMDS Quantitative Techniques for Managers by Dr. Ravi K.

Jaiswal

DECISION TREES (WORKED EXAMPLE)

Example: A property owner is faced with a choice of:

(a) A large-scale investment (A) to improve her flats. This could produce a substantial pay-off in
terms of increased revenue net of costs but will require an investment of ₹1,400,000. After extensive
market research it is considered that there is a 40% chance that a pay-off of ₹2,500,000 will be
obtained, but there is a 60% chance that it will be only ₹800,000.

(b) A smaller scale project (B) to re-decorate her premises. At ₹500,000 this is less costly but will
produce a lower pay-off. Research data suggests a 30% chance of a gain of ₹1,000,000 but
a 70% chance of it being only ₹500,000.

(c) Continuing the present operation without change (C). It will cost nothing, but neither will it
produce any pay-off. Clients will be unhappy and it will become harder and harder to rent the flats
out when they become free.

How will a decision tree help the taking of the decision?

Solution:

1. Draw the decision tree representing the options open to the property owner.
The tree starts with a decision point, a node, so start the tree with a square. Three lines radiate from
this, representing the three options. Label them carefully.

2. Add the chance nodes, the probabilities and the outcomes.


The options end with possible outcomes, so mark with a circle. In this case there are two possible
outcomes for the investment options, and only one for the 'as is' option. Add all the data to this
diagram.

3. Calculate the expected values


Now start to calculate, starting from the right. Multiply the outcomes by the relevant probability, and
then add the answers together for each option. Put answer above the appropriate circle.

Tree diagram now looks like figure below:


LBSIMDS Quantitative Techniques for Managers by Dr. Ravi K. Jaiswal

4. Calculate the net expected value

The final stage is to adjust for the costs of the options. Now subtract the costs of each option from the
expected value, and mark the calculation on the diagram. Reject the options with the lowest net
expected value.

The final tree diagram is shown below.

Advice to the owner:

The large-scale project has an expected value of ₹80,000, but the small-scale one shows an expected
value of ₹250,000. Hence, the small-scale project with high expected value looks the best option.

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