DECISION TREE APPROACH

Decision making process involves selecting the best

among several available decisions through proper
evaluations of parameters of each decision
In real life situation, decision making is a multi-stage
process.
Decision at stage i is dependent on the decision
made at stage i -1
At each stage, there will be a set of alternatives
For each alternative, there will be a set of chance
events.

symbol represents decision point at a given stage

from which a set of decision alternatives will originate.

symbol represents a chance point for a given

alternative from which chance events will originate.
Decision Tree approach helps the decision maker to
perform an analysis before arriving at optimum decision.

PROBLEM
- A company is planning production capacity for next 10
years.
- Demand for product may be High or Low.
- Company can build capacity assuming High Demand,
this will require higher investment.
- In case of High Demand situation, this capacity will be
economical in the long run.
- Second option is to plan the capacity on the basis of
Low Demand.

- Study market for 4 years and build additional capacity

in 5th year, if market so demands.
- Building additional capacity in 5th year will be more
costly than it would be now.
- Company estimated that High or Low Demand have
equal probabilities.
- If demand during first four years remains High, then
the probability that the demand will remain High in
next 6 years is 0.8.
- Probability of low demand in next 6 years is 0.2
- If demand during first four years remains low, then the
probability that the demand will remain low in next 6
years is 0.8.
- Probability of high demand in next 6 years is 0.2.
- Cash flows in terms of investments, maintenance, and
revenue for both options have time value.
- Present worth of all associated cash flows are given
in the following table.
Demand

Year 1 - 4

Year 5 10

Low

High

Low

High

Strategy S1

- 1000

5000

- 1500

7000

Strategy S2

200

1000

5000

3000

Find the optimal strategy which will maximize the expected

Pay-off.

High 0.8
7000
C

Low 0.2
(-)1500

High 0.5
High 0.2

7000

B
S1

Low 0.5

Low 0.8
(-)1500

High 0.8
3000

S2

High 0.5

Low 0.2
5000

E
High 0.2

3000
Low 0.5

Low 0.8
5000

Expected Pay-off at C = 7000X 0.8 1500 X 0.2 = 5300

Expected Pay-off at D = 7000X 0.2 1500 X 0.8 = 200
Expected Pay-off at F = 3000X 0.8 + 5000 X 0.2 = 3400
Expected Pay-off at G = 3000X 0.2 + 5000 X 0.8 = 4600

Expected Pay-off at B = 0.5 (5000+5300) + 0.5 (-1000 +200)

= 4750
Expected Pay-off at E = 0.5 (1000+3400) + 0.5 (200 +4600)
= 4600
Expected Pay-off at B > Expected Pay-off at E
Thus Strategy S1 shall be selected,
i.e., Build Capacity based on High Demand