Decision trees

Question 1

What tool are decision trees?

Answer 1

A decision making tool.

Question 2

Explain the nature and purpose of decision trees

Answer 2

• They are a mathematical model used to help managers make decisions when faced with choices.
• Aids decision making process.
• Whenever a firm is considering two/more options decision trees can be used to show the likely financial return for undertaking each of the options.
• They combine the risk (costs) and the likely return (revenues) from a given undertaking.

Question 3

What two aspects is the decision based on?

Answer 3

1) the profitability of a particular outcome (the risk)

2) the estimated monetary reward of a given option (the reward)

Question 4

What is the probability in decision trees?

Answer 4

• Is the % chance or possibility that an event will occur.
• Ranges between 1 (100%) and 0
• If all the outcomes of an event are considered, the total probability must add up to 1.

Question 5

What is the estimated monetary value? (EMV)

Answer 5

The financial value of an outcome calculated by multiplying the estimated financial effect x its probability. (two profit figures by their probability added together)

Question 6

What is the net gain?

Answer 6

The value to be gained from taking a decision.
-Net gain is calculated by = adding together the expected value of each outcome - the costs associated with the decision.

Question 7

What are some benefits of decision trees?

Answer 7

• Allows managers to analyse possible options + identify opportunity costs.
• Gives quantifiable figure that allows for comparison
• Forces manager to inject quantifiable analysis into the decision making process - rather than just relying on qualitative information)

Question 8

What are some drawbacks of decision trees?

Answer 8

• Accuracy of estimations - need to ensure internal data is good - businesses are affected by the external environment making accuracy of the probabilities questionable.
• Less useful when business is facing a new situation - don’t know data so potentially inaccurate information
• Managerial bias - managers pitching an idea have an interest in success and could manipulate data
• Doesn’t account for external factors

Question 9

Evaluation of decision trees

Answer 9

Only as useful as the quality of information that goes into their construction is reliable + with any quantitative decision making technique businesses shouldn’t rely on any one technique in isolation + should draw on range of quantitative + qualitative information.