Decision Trees

Question 1

What is a decision tree?

Answer 1

A mathematical model used to help managers make decisions. Estimates and probabilities are used to calculate likely outcomes. Shoes the likelihood that the net gain from a decision will be worthwhile.

Question 2

Define probability

Answer 2

The chance of an outcome happening.

Question 3

Define expected value.

Answer 3

The financial value of an outcome calculated by multiplying the estimated financial effect by its probability.

Question 4

Define net gain.

Answer 4

The value to be gained from making a decision. Calculated by adding together the expected value of each outcomes and deducting the costs associated with the decision.

Question 5

What are the advantages of decision trees?

Answer 5

• choices are set out in a logical way.
• potential options and choices are considered at the same time.
• use of probabilities enables the risk of the options to be addressed.
• likely costs are considered as well as potential benefits.
• easy to understand and tangible results.

Question 6

What are the disadvantages of decision trees?

Answer 6

• probabilities are just estimates - always prone to errors.
• uses quantitative data only - ignores qualitative aspects of decisions.
• assignment of probabilities and expected values prone to bias.
• decision making technique doesn’t necessarily reduce amount of risk.

Question 7

Summarize decision trees.

Answer 7

• a popular tool for management decision making.
• output from decision trees very sensitive to the probabilities assigned.
• important not to use them to justify a decision, but to aid decision making.

Question 8

Summarize decision trees.

Answer 8

• a popular tool for management decision making.
• output from decision trees very sensitive to the probabilities assigned.
• important not to use them to justify a decision, but to aid decision making.