3.3.3 decison trees

Question 1

what are decision trees

Answer 1

A simple and visual way of presenting the alternative course of action available when making a decision
A mathematical model based on logic and probability

Question 2

decision trees identify

Answer 2

When a decision has to be made
The choices available
The cost associated with each option
The possible outcomes related to each choice
The likelihood (probability) of each outcome occurring
The estimated financial result of each outcome

Question 3

Decision trees are drawn using the following tools:

Answer 3

square
circle
line

Question 4

describe what the square circle and line are called and what they do

Answer 4

square-A decision node – this is used where a decision has to be made i.e. the option with the lowest financial outcome is discarded at this point and the highest financial outcome shown in the box

circle-A chance node - this is used where there are a number of possible outcomes. A calculation is carried out here to work out the expected value

A line -is used to show the options and the possible outcomes

Question 5

how to calculate decision trees

Answer 5

Calculate from right to left
First calculate the expected value
Multiply the financial outcome by the probability for each chance
Add the results together

Second calculate the net gain
Subtract the cost from the expected value

The highest net gain is shown in the decision nodes (the square) and the other options crossed off with a single line

Subtract Add Multiply

Question 6

Use and value of decision trees

advantages

Answer 6

Clearly show the options available

Encourages logical thinking

Allows structured discussions and comparisons

Takes into account risk

May raise alternative options

Quantifies the outcome of each decision

Highlights the likelihood of each outcome

Question 7

Use and value of decision trees

disadvantages

Answer 7

Relies heavily on estimates i.e. probabilities and financial outcomes

Doesn’t take into account qualitative factors

Estimates may be biased

May not consider external influences e.g. if the cost of one option is substantially higher will this be affected by interest rates

Non dynamic – may be out of date before a decision is reached

Question 8

Influences on decision making include

Answer 8

Mission – does the decision fit in with the business’ overall purpose?

Objectives – will the decision help the business achieve its goals within the specified time period?

Ethics – is the decision morally right? Are the managers comfortable with the decision i.e. does it meet their own ethical standards?

The external environment including competition – how will changes in the external environment e.g. fluctuations in the economy or competitors ’actions influence the financial outcomes and the probabilities? Will this have a major impact on uncertainty in decision making?

Resource constraints – even if a decision looks like the right one is it achievable with the resources available, including:
Time
Human resources
Expertise
Finance