DECISION TREE

DECISION TREE

Decision-making problems discussed so far are referred to a single

stage decision problems, because the payoffs, state of nature,
course of action and probabilities associated with the occurrence of
states of nature are not subject to change.

However, situations may arise when decision-maker needs to revise

his previous decisions on getting new information and make a
sequence of other decision. Thus, the problem becomes a multi-stage
decision problem because the consequence of one decision affects
future decision.
 DECISION TREE

For example, in the process of marketing a new product, the first

decision is often test marketing and the alternative courses of action
might be either intensive testing or gradual testing.

Given various possible consequences-favourable fair, or poor, the

decision-maker may be required to decide between redesigning the
product, and aggressive advertising campaign or complete withdrawal of
product and so on.

Given that decision, there will be an outcome which leads to another

decision and so on.
DECISION TREE

Decision tree is a graphical representation of

various decision alternatives and the sequence
of events as if they are branches of a tree.
DECISION TREES

A decision node is usually represented by a square and

indicates places where a decision-maker must make a
decision.
Each branch leading away from a decision node represents
one of the several possible courses of action (alternative)
available to the decision-maker.
DECISION TREES

The chance node is represented by a circle and indicates

a point at which the decision-maker will discover the
response to his decision, that is, different possible
outcomes which can result from a chosen course of action.
The respective payoffs and the probabilities associated with
alternatives courses and the chance event are shown
alongside these branches.
 DECISION TREES
At the end of the chance node, the expected values of the
outcomes are shown.
Possible payoffs and the probabilities associated
course of with alternatives courses
action
(alternative)
EMV is
calculated
Decision from the
node different
outcomes

different possible outcomes

which can result from a chosen
course of action
DECISION TREES

The general approach used in decision tree analysis is to work

backward through the tree from right to left.
Computing the expected value of each chance node.
We then choose the particular branch leaving a decision node
which leads to the chance node with the highest expected
value. This is known as roll back or fold back process.
DECISION TREE ANALYSIS - STEPS

Identify the decision At each decision point

points and the determine the probability Commencing from the
alternative course of extreme right end,
and the payoffs
action at each decision computed the EMV for
associated with each
point systematically
course of action each course of action
DECISION TREE ANALYSIS - STEPS

Choose the course Proceed Repeat above Finally, identify the

of action that yields course of action to

backwards to the steps till the
the best payoffs for be adopted from
next stage of first decision
the beginning to the
each decisions
decision points point is reached end
Example: 1
A Growfast company is evaluating four alternatives single-period investment opportunities whose returns
are based on the state of the economy. The possible states of the economy and the associated probability
distribution is as follow:
State Fair Good Great

Probability 0.2 0.5 0.3

The return for each investment opportunity and each state of the economy are as follows:

Alternative Fair (Rs.) Good (Rs.) Great (Rs.)

W 1000 3000 6000

X 500 4500 6800

Y 0 5000 8000

Z -4000 6000 8500

Using the decision-tree approach, determine the expected return for each alternative.which alternative
investment proposal would you recommend if the expected monetary value criterion is to be employed?
 Fair 0.2 1000
Alternative W
Good 0.5 3000 0.2 X 1000 = 200
0.5 X 3000 = 1500
Great 0.3 6000 0.3 X 6000 = 1800
EMV = 3500
Fair 0.2 500

W Good 0.5 4500 Alternative X

0.2 X 500 = 100
Great 0.3 6800 0.5 X 4500 = 2250
X 0.3 X 6800 = 2040
EMV = 4390
Fair 0.2 0
Y Alternative Y
Good 0.5 5000 0.2 X 0 = 0
0.5 X 5000 = 2500
Z Great 0.3 8000
0.3 X 8000 = 2400
EMV = 4900

Fair 0.2 -4000 Alternative Z

0.2 X -4000= -800
Good 0.5 6000
0.5 X 6000 = 3000
0.3 X 8500 = 2550
Great 0.3 8500
EMV = 4750
 Alternative EMV

W 3500

X 4390

Y 4900

Z 4750

Since EMV is the highest for the alternative Y investment proposal

should be recommended.
Example: 2
An executive has to make a decision. he has four alternatives D1, D2, D3, and D4. When the
decision has been made, events may lead such that any of the four results R1, R2, R3, and R4
may occur. Probabilities of occurrences of these results are follows:
R1 : 0.5 ; R2 : 0.2 ; R3 : 0.2 ; R4 : 0.1

The matrix of pay-offs between the decision and the results is indicated below:

R1 R2 R3 R4
D1 14 9 10 5
D2 11 10 8 7
D3 9 10 10 11
D4 8 10 11 13

Show this situation in the form of a decision tree and indicate the most preferred decision and
corresponding expected value.
 R1 0.5 14 Alternative D1
R2 0.2 9 0.5 X 14 = 7.0
0.2 X 9 = 1.8
R3 0.2 10 0.2 X 10 = 2.0
0.1 X 5 = 0.5
R4 0.1 5 EMV = 11.3 Alternative D2
D1 R1 0.5 11 0.5 X 11 = 5.5
0.2 X 10 = 2.0
R2 0.2 10 0.2 X 8 = 1.6
D2 0.1 X 7 = 0.7
R3 0.2 8 EMV = 9.8
R4 0.1 7 Alternative D3
D3 R1 0.5 9 0.5 X 9 = 4.5
0.2 X 10 = 2.0
R2 0.2 10 0.2 X 10 = 2.0
0.1 X 11 = 1.1
R3 0.2 10
D4 EMV = 9.6
R4 0.1 11 Alternative D4
0.5 X 8 = 4.0
R1 0.5 8
0.2 X 10 = 2.0
R2 0.2 10 0.2 X 11 = 2.2
0.1 X 13 = 1.3
R3 0.2 11
EMV = 9.5
R4 0.1 13
 Alternative EMV

D1 11.3

D2 9.8

D3 9.6

D4 9.5

Since EMV is the largest for the proposal D1. D1 should be undertaken.
Example: 3
Mr. X, the owner of a garment-shop is considering a move from street-shop to a
new shopping mall. Because he has been at the shop street for 20 years and has
built up quite a following there, Mr.X thinks there is a 20% chance his business will
decline by Rs.1,00,000 a 30% chance it will remain stable, and a 50% chance it will
increase by Rs.1,75,000 due to the quality of sales promotion done by the mall
management.

Further, the city is considering a city revitalization with a mall in front of Mr.X’s
store. he believes there is 70% chance this will pass the city council; if it does, he
estimates his business should increase by Rs.2,00,000. if the mall is not built he
thinks his street shop business will decline by about Rs.50,000. Time is of the
essence; the mall owners need an answer immediately or he will lose any chance to
locate there. construct a decision tree to help Mr.X decide on a course of action.
 Decline 0.2 -1,00,000
Move to mall
02 x -1,00,000 = -20,000
Stable 0.3 0 0.3 x 0 =0
a ll 0.5 x 1,75,000 = 87,500
m
to EMV = 67,500
e Increase 0.5 1,75,000
ov
M

St
st ay Increase 0.7 2,00,000
re a
et t t Stay at the street shop
sh he
op 0.7 x 2,00,000 = 1,40,000
0.3 x -50,000 = -15,000
EMV = 1,25,000
Decrease 0.3 -50,000
 Alternative EMV

Move to mall 67,500

Stay at the street 1,25,000

shop

Since EMV is greater in case he stays at the current street shop, Mr.X may
be advised to stay at the present place.
Example: 4
The investment staff of TNC Bank is considering four investment proposals for a
client-shares, bonds, real estates and saving certificate. These investments will be
held for one year.
The past data regarding the four possible propsals are given below:
(i) Shares : There is 25% chance that shares will decline by 10%, a 30% chance
that they will remain stable and 45% chance that they will increase in value by 15%.
also the shares under consideration do not pay any dividends.
(ii) Bonds : These bonds stand a 40% chance of increase in value by 5% and 60%
chance of remaining stable and they yield 12%.
(iii) Real Estate : This proposal has 20% chance of increasing 30%, in value, a 25%
chance of increasing in 20% value, a 40% chance of increasing in 10% value, a 10%
chance of remaining stable and 5% chance of losing 5% of its value.
(iv) Savings certificate : These cerificate yield 8.5% with certainty.
Use a decision-tree to structure the alternatives available to the investment staff,
and using the expected value criterion, choose the alternative with the highest
expected value.
 Decline 0.25 -10
Shares
0.25 x -10 = -2.5
Stable 0.30 0 0.30 x 0 = 0
0.45 x 15 = 6.75
EMV = 4.25
es
Increase 0.45 15 Bonds

ar Increase 0.4 5
0.4 x 5 = 2

S h 0.6 x 0 = 0
yield 12% = 12.0
EMV = 14.0
n d s
Bo Stable 0.6 0

Re Increase 0.2 30 Real Estate

Es al Increase 0.25 20 0.2 x 30 = 6
ta 0.25 x 20 = 5
te
Sav ificat

0.4 x 10 = 4
Cer

Increase 0.4 10 0.4 x 0 = 0

ings

0.05 x -5 = -0.25
t

Stable 0.4 0 EMV = 14.75

Loss 0.05 -5 Savings

e

Ceritificate
1 x 8.5 1 x 8.5 = 8.5
EMV =8.5
 Alternative EMV
Shares 4.25

Bonds 14.0

Real Estate 14.75

Savings Certificate 8.5

Invest in Real Estate

Example: 5
Stereo Industries Ltd., must decide to built a large or small plant to produce a new
turntable which is expected to have a market life of 10 years. A large plant will
cost Rs. 28,00,000 to built and put into operation while a small will cost only
Rs.14,00,000 to built and put into operation. The company’s best estimate of a
discrete distribution of sales over the 10 year period is :
High demand probability = 0.5
Moderate demand probability = 0.3
Low demand probability = 0.2
Cost-Volume-Profit analysis done by the management at stereo industries ;td.,
indicates, these conditional outcomes under the various combinations of plant size
and market size.
1) A large plant with high demand would yield Rs.10,00,000 annually in profits.
2) A large plant with moderate demand would yeild Rs.6,00,000 annually in profits
3) A large plant with low demand would lose Rs.2,00,000 annually because of
production inefficiencies.
Example: 5
4) A small plant with high demand would yield only Rs.2,50,000 annually in profits,
considering the cost of the lost sales because of inability to supply customers.
5) A small plant with moderate demand would yield Rs.4,50,000 annually is profits
because the cost of lost sales would be somewhat lower.
6) A small plant with low demand would yield Rs.5,50,000 annually because the plant
size and market size would match fairly optimally.
Construct the decision tree and find out the EMV.
 HD 0.5 10 X 10 Large plant
0.5 X 10 X 10 = 50.0
0.3 X 6 X 10 = 18.0
MD 0.3 6 X 10 0.2 X -2 X 10 = -4.0
nt
pl a EMV = 64.0
r ge LD 0.2 -2 X 10 cost to built = 28.0
La EMV = 64 - 28 = 36.0

Sm
a Small plant
ll p HD 0.5 2.5 X 10 0.5 x 2.5 x 10 = 12.5
lan 0.3 x 4.5 x 10 = 13.5
t
0.2 x 5.5 x 10 = 11.0
MD 0.3 4.5 X 10 EMV = 37.0
Cost to built = 14.0
EMV = 37 -14 = 23.0
LD 0.2 5.5 X 10
 Alternative EMV
Large plant 36.0

Small plant 23.0

Since EMV is greater for large plant the company may be advised to construct a
large plant.
Example: 6
A businessman has two independent investments. A and B available to him; but
he lacks the capital to undertake both of them simultaneously.

He can choose to take A first and then stop, or if A is successful then take B,
or vice versa.
The probability of success on A is 0.7, while for B it is 0.4.

Both investments require an initial capital outlay of Rs.2,000 and both return
nothing if the venture is unsuccessful.

Successful completion of A will return Rs.3,000 (over cost) and successful

completion of B will return Rs.5,000.

Draw the decision tree and determine the best strategy.

 ce ss 0.4 X 0.7 5,000 0.4 X 0.7 X
S u c
5000 = 1400
Choose B 0.6 X 0.7 X
-2000 =
0.7 3,000 0.6 X 0.7 -2,000
ss
Fa -840
e
cc
ilu EMV = 560
re
Su

STOP
A
se

0.7 X 3000 = 2100

oo

Fa 0.3 -2,000 0.3 X -2000 = - 600

Ch

ilu EMV = 1500

re
s
0.7 X 0.4 3,000
ces 0.4 X 0.7 X
Suc 3000 = 840
0.4 5,000 Choose A
s

0.4 X 0.3 X
es
cc

-2000 =
Ch

Su
oo

Fa 0.3 X 0.4 -2000 -240

se

ilu
re EMV = 600
B

Fa
ilu 0.6 -2,000 0.4 X 5000 = 2000
re 0.6 X -2000 = -1200
EMV = 800
STRATEGY

STRATEGY PROFIT
1)Choose A and stop 1,500
2) Choose A and if successful 1,500 + 560 = 2,060
choose B
3) Choose B and stop 800
4) Choose B and if successful 800 + 600 = 1,400
choose A

Conclusion : the best strategy is to choose A and if successful Choose B

Example: 7
A company is contemplating whether to produce a new product. if it decision to produce the product
it must either install a new division which needs a cost outlay of four lakh rupee, or work overtime
with overtime expenses of Rs.1.5 lakhs. if the company decide to install a new division, it needs
approval of government, and the company feels that there is a 70% chance of getting the approval.
A market survey has revealed the following facts regarding the magnitude of sales for the new
product.
Magnitude Probability Resulting profit (in Rs.
of sales lakhs)
High .45 15
Medium .30 7
Low .20 3
Nil .05 -5 (loss)
However by resorting to overtime, the company will not be in a position to meet the high
magnitude of sales. it will be able to satisfy upto the level of medium magnitude only, even if
high magnitude of sales results.
solve the problem to suggest : Which option should be selected?
 Do not produce new product
Not Approved HD 0.45 15

0.3 MD 0.3 7
New Division Approved
A B
...4 0.7
LD 0.2 3
Produce new product
1 2 NOD 0.05 -5
HD 0.45 7

MD 0.3 7

...1.5
C
Over time
LD 0.2 3

NOD 0.05 -5
EMV at C 7 X 0.45 + 7 X 0.3 + 3 X 0.2 + (-5) X 0.05 = 5.6
EMV at B 15 X 0.45 + 7 X0.3 + 3 X 0.2 X (-5) X 0.05 = 9.20
EMV at A 7 X 9.20 + 3 X 0 = 6.440
EMV at 2 Maxi [6.44-4, 5.6-1.5]
Maxi (2.44, 4.1)
4.1 Lakhs
EMV at 1 Max [4.1 , 0]
Max = 4.1 lakhs

Conclusion: The company should go for the new product by

resorting to overtime.
 Example 8:
A finance Manager is considering drilling a well. In the past, only 70% of wells drilled
were successful at 20 metres depth in that area. Moreover on finding no water at 20
metres, some persons in that area drilled it further upto 25 metres but only 20% struck
water at that level. the prevailing cost of drilling is Rs.500 per meter. The Finance
Manager estimated that in case he does not get water in his own well, he will have to pay
Rs.15,000 to buy water from outside for the same period of getting water from the well.
the following decisions are considered :

(i) Do not drill any well

(ii) Drill upto 20 meters and
(iii) If no water is found at 20 metres, drill further upto 25 metres.
Draw an appropriate decision tree and determine the finance manager’s strategy.
 0.7 10,000 0.20 12,500

er
er

at
W
at
Drill 25m. more

W
Drill upto 20m
B
A N
N o 0.80
o W
W 0.3 at
at 2 er
er Rs.15,000 +12,500
= 27,500

1
Buy water 10,000 + 15,000
= 25,000
Do not Drill
and Buy water Rs.15,000
EMV at B 0.20 X 12,500 + 0.80 X 27,500 = 24,500

EMV at B Min (24,500 ; 25,000 ) = 24,500

EMV at A 0.7 X 10,000 + 0.3 X 24,500 = 14,350
EMV at 1 Min (14,350, 15,000) = 14,350

Conclusion: Drill upto 20 metres and if no water is in this level, drill 5 more
metres and still no water is found then buy water from outside.