Decision Trees

Question 1

Define decision trees

Answer 1

A quantitative approach of decision-making. Each decision is expressed as a number and any chance of something happening is expressed as the probability of it occurring. They are useful for analysing situations where a sequence of events need to be followed to achieve an outcome, but the outcome is uncertain. They consider the probability of failure.

Question 2

Advantages of decision trees

Answer 2

• Clearly lay out the problem so that all options can be considered.
• Allow managers to analyse fully the possible consequences and risks of a decision.
• Provide a framework to quantify the values of outcomes and the probabilities of achieving them.
• Decision trees give an easy-to-understand visual representation of the problem.

Question 3

Disadvantages of decision trees

Answer 3

• Can oversimplify a decision and focus too much on the financial outcome.
• Don’t include other factors such as manpower considerations, managers’ opinions and marketing
  issues.
• Probabilities are difficult to predict and may reflect bias.
• There may be other options that are not included in the decision tree.
• Can be time consuming to construct and may be interpreted with bias.
• Time lags often occur in decision-making so information may be out of date.
• Use probabilities which only gives an estimate which may be inaccurate.

Question 4

Construct a decision tree

Answer 4

• Success - Profit/Loss
  - A - Failure - Profit/Loss
  square
  (decision)
  - B -Success -Profit/Loss
  -Failure -Profit/Loss
  expected value for A = (successxprofit)+(failurexloss)