E 3.3.3 decision trees*

Question 1

decision trees definition

Answer 1

a method of tracing the alternative outcomes of any decisions in order to help the business make the right decision.

Question 2

features of a decision tree

Answer 2

• decision points: represented by SQUARE
• outcomes: represented by CIRCLE
• it is possible to have numerous outcomes e.g. very successful, averagely successful and failure.

Question 3

how to calculate expected monetary value

Answer 3

1. multiply the probability for each outcome by the expected profit/loss/cashflow
2. add these values together for each outcome. this is your EMV
3. deduct the cost of the decisions (if available) THIS IS THE NET GAIN
4. compare the EMV/NET GAIN of each outcome- the higher value choice should be chosen as it has the largest return. Cross through the options you are not choosing with 2 lines

the question does not always give you the cost of the decision. in this case, you just calculate the EMV

Question 4

example of a decision tree

Answer 4

if Colin plants potatoes he estimates that the probability of good crop is 0.3, which will generate £50000 profit. the probability of an average crop is 0.3 which would result in $30000 profit. the probability of a poor crop it 0.4 which would result in only £10000 profit.
if swedes are planted, either a good crop or bad crop will result. he estimates the probability of 0.5 in each case. A good crop will generate £40000 and a poor crop only £10000 good 0.3% —-
potatoes= average 0.3% —-
/ bad 0.4% —-
SQUARE
\ good 0.5% —-
swedes= bad 0.5% —-

G- 50000 x0.3= 15000
A- 30000 x0.3= 9000 + = 28000 (EMV)
B- 10000 x0.4= 4000

G- 40000 x0.5= 20000 + = 25000 (EMV)
B- 10000 x0.5= 5000

POTATOES IS BEST OPTION

cant calculate net gain on this tree but to calculate the NET gain:

price of the option - EMV