Decision trees Flashcards
1
Q
Define DECISION TREES
A
Decision trees are mathematical models used to help managers make decisions. It uses estimated returns and probabilities to calculate likely outcomes, helping to decide whether the net gain from a decision is worthwhile.
2
Q
Define EXPECTED VALUE
A
An expected value is the anticipated value of an investment. Calculated by multiplying each of the possible outcomes by the probability of that outcome happening and summing all those values.
3
Q
What are the advantages of decision trees?
A
- Forces managers to carefully consider the impacts, outcomes and options involved in a decision using methodical methods.
- The inclusion of probability may make them more useful than investment appraisal techniques.
- Helps businesses see the best and worst case scenario which is helpful if the decision could threaten a firm’s survival.
4
Q
What are the disadvantages of decision trees?
A
- Only as useful as the data within them - how accurate are the probabilities?
- Risk of unreliable data with one off or first time decisions
- Risk of management bias
- Only focuses on quantitative data
- Non-dynamic and may be out of date before a decision can be reached.
5
Q
How do you construct a decision tree?
A
- Draw a square decision node to show that a decision needs to be made.
- Draw lines coming out of it to indicate different options. Write the name of the option above the line and the costs of it below.
- Draw circular chance nodes to indicate that the outcome is not certain.
- Draw lines coming out of each chance node to show the different possible outcomes and write the probability that each happens under the line.
- Write the estimated financial return for each option.
- Work out the expected values (probability x return) and add them up for that option. Minus the cost to calculate net gain for that option.
6
Q
Define NET GAIN
A
Net gain is the value that will be gained by taking a decision. It is calculated by deducting the cost of the investment from its expected value.
