Tools for Financial Decision

Making: Decision Trees

Session 5
 Imperfect Information
• Many business problems contain uncertain
elements that are impossible to ignore
without losing the essence of the situation.
• Why?
• Risk and associated loss
 What to do?
• To put things into perspective
• Use the information you have
• How?
• Decision tree
• It is a graphical representations of a problem
 Uncertain Parameters
• Uncertain parameters become known only after a decision is made.
• When a parameter is uncertain, we treat it as if it could take on two
or more values, depending on influences beyond our control.
• These influences are called states of nature, or more simply, states.
• In many instances, we can list the possible states, and for each one,
the corresponding value of the parameter.
• Finally, we can assign probabilities to each of the states so that the
parameter outcomes form a probability distribution.
 Using Trees to Model Decisions
• A probability tree depicts one or more random
factors
• The node from which the branches emanate is
called a chance node, and each branch represents
one of the possible states that could occur.
• Each state, therefore, is a possible resolution of the
uncertainty represented by the chance node.
• Eventually, we’ll specify probabilities for each of
the states and create a probability distribution to
describe uncertainty at the chance node.
 Homework
• Quantify the qualitative decision tree shown
on slide 6.
• Make your assumptions about the pay-offs
and the probabilities.
• Solve the problem.
 In Finance
• When it comes to the finance area, decision
trees are a great tool to help organize
thoughts and to consider different scenarios
 How to Create a Decision Tree?
1. Write the main decision.
– Begin the decision tree by drawing a box (the root
node) on 1 edge of your paper. Write the main
decision on the box.
2. Draw the lines 
– Draw line leading out from the box for each
possible solution or action. Keep the lines as far
apart as you can to enlarge the tree later.
3. Illustrate the outcomes of the solution at the
end of each line.
– It is a good practice here to draw a circle if the
outcome is uncertain and to draw a square if the
outcome leads to another problem.
4. Continue adding boxes and lines.
– Continue until there are no more problems, and all
lines have either uncertain outcome or blank
ending.
5. Finish the tree.
– The boxes that represent uncertain outcomes
remain as they are.
– A very good practice is to assign a score or a
percentage chance of an outcome happening. 
– For example, if you know for a certain situation
there is 50% chance to happen, place that 50 % on
the appropriate branch.
 Incorporating Probabilities
• Start analyzing the tree for the payoffs
corresponding to each of the potential actions.
• Use the notation EP to represent an expected
payoff (e.g., an expected profit).
• Note that the expected payoff calculation
ignores no information: all outcomes and
probabilities are incorporated into the result.
– Not doing anything is also a choice.
Payoff Tables and Decision Criteria
• For each action-state combination, the entry in
the table is a measure of the economic result.
• Typically, the payoffs are measured in monetary
terms, but they need not be profit figures.
• They could be costs or revenues in other
applications, so we use the more general term
payoff.
 Analyzing the Decision Tree
• Whereas we build the tree left to right, to reflect the
temporal sequence in which a decision is followed by a
chance event, we evaluate the tree in the reverse
direction.
• At each chance node, we can calculate the expected
payoff represented by the probability distribution at the
node.
• This value becomes associated with the corresponding
action branch of the decision node.
• Then, at the decision node, we calculate the largest
expected payoff to determine the best action.
• This process of making the calculations is usually referred
to as rolling back the tree.
 Class work
• Potter & Weasley Magical Ltd. is deciding whether to
develop and launch a new product, a flying broom,
Nimbus Starship.
• Research and development costs are expected to be
$400,000 and there is a 60% chance that the product
launch will be successful, and a 40% chance that it will fail.
• If it is successful, the levels of expected profits and the
probability of each occurring have been estimated as
follows, depending on whether the product’s popularity is
high, medium or low
If it is a failure, there is a 0.8 probability that the
research and development work can be sold for
$45,000 and a 0.2 probability that it will be worth
nothing at all.
Decision Trees for a Series of Decisions
• Decision trees are especially useful in situations where there
are multiple sources of uncertainty and a sequence of decisions
to make.
• For example, suppose that we are introducing a new product
and that the first decision determines which channel to use
during test-marketing.
• When this decision is implemented, and we make an initial
commitment to a marketing channel, we can begin to develop
estimates of demand based on our test.
• At the end of the test period, we might reconsider our channel
choice, and we may decide to switch to another channel.
• Then, in the full-scale introduction, we attain a level of profit
that depends, at least in part, on the channel we chose initially.
 Advantages
• It is very easy to understand and interpret.
• The data for decision trees require minimal preparation.
• They force you to find many possible outcomes of a decision.
• Can be easily used with many other decision tools.
• Helps you to make the best decisions and best guesses on
the basis of the information you have.
• Helps you to see the difference between controlled and
uncontrolled events.
• Helps you estimate the likely results of one decision against
another.
 Disadvantages
• Sometimes decision trees can become too
complex.
• The outcomes of decisions may be based
mainly on your expectations. This can lead to
unrealistic decision trees.
• The diagrams can narrow your focus to critical
decisions and objectives.
 Using Decision Tree Software
• It is often difficult to create a layout for the
calculations that is tailored to the features of a
particular example.
• For that reason, it makes sense to take
advantage of software that has been designed
expressly for representing decision trees in
Excel.
• Edraw is one such software that we’ll learn to
use in the next session