Vanguard Decision Tree Analysis

A D D

I N

User's Guide

The information in this document is subject to change without notice and does not represent a commitment on the part of Vanguard Software Corporation. No part of this manual may be reproduced or transmitted in any form or by any means, electrical or mechanical, including photocopying and recording, for any purpose other than the purchaser's personal use without the written permission of Vanguard Software Corporation. 2008. Vanguard Software Corporation. All rights reserved.

Vanguard System, Vanguard Server, Vanguard Studio, and DScript are trademarks of Vanguard Software Corporation. Windows is a registered trademark of Microsoft Corporation. v5.1.0

ii Vanguard Decision Tree Analysis Add-in User's Guide

Table of Contents
Getting Started............................................................................. 1
Decision Tree Analysis Add-in Overview ........................................... 2 System Requirements........................................................................ 2 Installing Your Add-in ......................................................................... 2

Decision Tree Analysis ............................................................... 5

Decision Tree Basics ......................................................................... 6

Building Decision Trees.............................................................. 9

Solving Problems with Decision Trees............................................. 10 Calculating a Solution ...................................................................... 14 Interpreting Your Results ................................................................. 14 Choosing Event Probabilities ........................................................... 15 Editing Node Formulas..................................................................... 17 Decision Trees with Discounted Cash Flows................................... 18

Analyzing Decision Trees ......................................................... 21

Risk Profile Graphs .......................................................................... 22 Break-Even Analysis ........................................................................ 23 Value of Perfect Information............................................................. 24

Risk Aversion............................................................................. 27
Assessing Risk ................................................................................. 28 Using Risk Aversion ......................................................................... 31

Markov Simulation..................................................................... 33
Markov Models ................................................................................. 34

Index ........................................................................................... 41

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C h a p t e r

Getting Started
Contents
Decision Tree Analysis Add-in Overview System Requirements Installing Your Add-in

This chapter provides basic information about installing your Add-in, and the steps taken to access the Add-in within Studio.

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Chapter 1

Decision Tree Analysis Add-in Overview

Once you have modeled a decision using this Add-in, Studio will automatically analyze the tree to help you better understand and communicate the risks involved. For example, with the Add-in capabilities, Studio can automatically construct a risk profile graph or table illustrating all possible outcomes and probabilities. You also will be able to calculate the value of knowing what will happen in the future (value of perfect information). This helps you determine how much you should spend on market or other research to refine your assumptions. The Decision Tree Analysis Add-in even allows you to specify your personal risk aversion when constructing decision models. Whats more, the Markov simulation tool, also included in this Add-in, will help you predict how dynamic systems behave over time. Through the use of specific examples, this Users Guide will demonstrate how to take full advantage of your Add-ins capabilities. You will be building decision trees like a pro in no time.

System Requirements
Vanguard Studio 5.0 Hard disk with at least 10 MB of free space CD-ROM drive

Installing Your Add-in

Note: Depending upon your purchase, the install will include Studio and an Add-in together; or, an Add-in will install on top of Studio that already resides on your computer.

To install an Add-in on your computer, follow these instructions: 1) Reboot your computer. 2) Install Studio first, if you have purchased Studio separately from the Add-in. If you have purchased a suite (Studio + one or more Addin(s)), Studio and the Add-ins will install together. 3) Insert the Setup CD in your CD-ROM drive. The setup program will start automatically. If it does not start automatically, - Click the Start button and then click Run, - Type drive:\setup and then click OK. 4) Follow the instructions in the setup program. If you encounter any problems installing, free technical support is available from 9:00 AM to 5:00 PM ET Monday through Friday by calling 919-859-4101. Support is also available through our Web site at http://www.vanguardsw.com.

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Getting Started

Starting Studio
When Studio is installed, the setup program automatically creates the Vanguard program group in your Start menu. To start Studio, click the Start button, point to All Programs, Vanguard 5, and click Vanguard Studio.

Finding the Add-in

Once installed, the Add-in integrates with Studio to give you the additional functionality you require. You can access the Add-ins features by choosing the appropriate option under the Tools menu. Documentation for the Add-in can be found by clicking User Guides under Help.

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Decision Tree Analysis

Contents
Decision Tree Basics

This chapter provides an introduction to decision trees including background theory and descriptions of the various components that make up a Vanguard decision tree.

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Decision Tree Basics

Decision trees are used to select the best course of action in situations where you face uncertainty. Many business decisions fall into this category. For example, a manufacturer must decide how much inventory to build before knowing precisely what demand will be. A litigant must choose between accepting an out-of-court settlement or risking a trial. A speculator must decide to buy an asset before knowing if it can be sold for a profit. In all of these cases, the decision-maker faces an unknown that seems to make it impossible to choose the right option with any certainty. Although the decision-maker does not know what the outcome of the unknown will be, he or she generally has some knowledge about what the possible outcomes are and how likely each is to occur. This information can be used to select the option that is most likely to yield favorable results. Decision trees make this type of analysis easy to apply.

Expected Monetary Value

If you could somehow determine precisely what will happen as a result of choosing each option in a decision, making business decisions would be easy. You can simply calculate the value of each competing option and select the one with the highest value. In the real world, decisions are not quite this simple. However, the process of decision-making still requires choosing the most valuable optionmost valuable being, in this case, the option that has the highest Expected Monetary Value (EMV), a measure of probabilistic value. Suppose you are given the opportunity to play a simple game. A friend flips a coin. If it comes up heads, you win $100. If it comes up tails, you win nothing. What is the value of this game to you? Stated another way, how much would you pay to play this game? Each time you play the game you have a 50% chance of winning $100 and a 50% chance of winning nothing. If you were to play the game many times, on average you would win $50 for every time you played. Therefore, $50 is the EMV for this game. Graphically, this game can be illustrated as follows:
50% Win $100 50% Lose $0

Play Game $50

This diagram shows that there is an uncertain event with two possible outcomes. Win, which has a value of $100, and Lose, which has a value of $0. Furthermore, there is a 50% chance of each outcome. Finally, the EMV of this event is $50. This simple diagram does an excellent job of communicating all essential details of the situation you face.

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The EMV is calculated by multiplying each outcome value by its probability and adding all of the results together.
EMV = Valuen Probabilityn
n =1 N

In the diagram above, the EMV was calculated using the equation EMV = $100 * 0.50 + $0 * 0.50 = $50 The value shown under each node name is the expected value of reaching that point in the tree. Before playing the game, you are at the Play Game node and the combined value of all events following this node is $50. Similarly, if you win, you move to the Win node with a value of $100.

Decision Diagrams
Now, suppose your friend offers you the opportunity to play the game presented in the previous section or simply accept $40 cash. What should you do? Playing the game is worth $50, which is more valuable than $40, so you should play the game. This decision can be illustrated as follows:
50% Win $100 50% Lose $0

Root $50

Play Game $50 Accept Cash $40

This diagram contains two new nodes: Root and Accept Cash. Note that Root is presented slightly differently from Play Game. Root is followed by a square, rather than a circle, and there are no outcome probabilities on the branches leading from Root. Furthermore, the value of the node Root is not a weighted average of option values, but is exactly equal to the value of only one of the options. Root is called a decision node. Play Game is called an event node. All other nodes are called end nodes. At a decision node, you get to pick which path you want to take. Being a rational decision-maker, you would choose the path with the highest value. Therefore, the value of a decision node is equal to the value of the best option branching from the node. In the example above, the best option is to play the game, which has a value of $50, so the value of the decision node is also $50. The branch labeled Accept Cash is marked with a double slash to indicate that you would not choose this option; it has been pruned from the tree. The diagram above is called a decision tree. Decision trees map all options and potential consequences in a manner that makes it easy to understand and communicate the situation you face. As you move from left to right in the tree, you generally move forward in time. The root node is where you are now and immediately branches off into all options from which you can choose. What might happen as a result of choosing each option is illustrated as additional branches.

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Note that this tree has five nodes, not two. Because the tree is displayed without node boxes, it is a common mistake to refer to the junction points (square or circle) as nodes. In fact, these are just symbols that are appended to the back of each node. Keep in mind that Win, Lose, and Accept Cash are also nodes. They are end nodes and include a triangle symbol.

Incremental Values
Now, lets complicate the coin toss game a little. Just as before, you will win $100 if heads comes up, and nothing for tails. However, your options are to pay $40 to play this game or dont play at all. This game is illustrated using the following tree.
Win 50% 100 $60 50% Do Nothing 0 $0 Lose 0 ($40)

Root 0 $10

Play Game -40 $10

The first thing you might notice is that each node has three lines instead of two. Just as before, the top line contains the node name and the bottom line contains the calculated EMV. The middle line is new. This line contains the amount of cash you will pay or receive as a result of jumping to that node from its parentthe incremental value.
Node Name Incremental Value Calculated EMV

For example, if you decide to play the game, you will pay $40. This means that the Play Game node has an incremental value of -40. The value is negative because it is a cash outflow. Similarly, if you win the coin toss, you will receive $100. Therefore, Win has an incremental value of 100 (positive). Note that if you win the coin toss, you will not have earned $100. Instead, you will have a net profit of $60 ($100 winnings minus $40 to play). The net profit is shown in the EMV line. When you build a decision tree in Studio, you enter node names, incremental values, and outcome probabilities. Studio calculates the EMVs.

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Building Decision Trees

Contents
Solving Problems with Decision Trees Calculating a Solution Interpreting Your Results Choosing Event Probabilities Editing Node Formulas Decision Trees with Discounted Cash Flows

Using specific examples and instructions, this chapter guides you through constructing decision trees using the Decision Tree Analysis Add-in.

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Chapter 3

Solving Problems with Decision Trees

To help you become familiar with the Decision Tree Analysis Add-in, two example problems are included in this chapter Real Estate and Inventory. By working through these problems, using the instructions provided, you will learn how decision trees are built and applied. These examples will be referenced throughout this Users Guide.

Real Estate Example

You have the opportunity to purchase a piece of property for $200,000. If it can be rezoned for business use, you will be able to resell the property for $250,000. You estimate that there is a 60% chance that your rezone request will succeed. If it fails, you can dump the property for $170,000 or you can choose to appeal the zoning boards decision, which has only about a 10% chance of success. Applying for the zoning change and appealing an unfavorable ruling will each cost $5,000. Should you purchase the property?

Lets Build a Tree

To solve this problem with Studio, first point to New and then Decision Tree in the File menu. This will give you a list of templates you can use to begin your model. The templates are essentially blank models that have all style and calculation options set properly. Model Templates There are three decision tree templates: Basic, Long Names, and Wizard. The Basic and Long Names templates are the same except that the Long Names version uses comment fields in each node to display the node name. Since there are restrictions on what characters can be used in the name field, using the comment field to hold names is more flexible. For example, Buy & Rezone is not a legal node name because the ampersand is an operator. Using the Basic template, you will need to name this node Buy and Rezone. Using the Long Names version, you can use any characters you like, as well as duplicate node names. The Basic template requires each node name to be unique. Duplicating node names often simplifies building your tree, but is generally bad practice because it can lead to communication errors when discussing your tree with others. The primary disadvantage to the Long Names template is that the analysis tools report results using node names, not node comments. Unless you have a real need to use special characters in your node names, you are better off using the Basic template. Wizard Templates The Wizard template is designed to be used with the decision tree Build Wizard tool, which guides you through the construction of a tree. This is a great tool for building small trees when you are not familiar with Studio. However, building trees directly, using the Basic template is still the preferred method.

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Back to the Tree

After pointing to New and then Decision Tree in the File menu, click Basic. This will open a model that looks like this:
Root 0 Unevaluated

The problem states that you have two options from which to choose: buy the property for $200,000 or do nothing. To reflect these options, double-click on the triangle following Root. This will bring up the Insert Branch dialog box:

Next, click on the Decision Node button. This causes Studio to add two additional branches following Root.
Option1 0 Unevaluated Option2 0 Unevaluated

Root 0 Unevaluated

Studio automatically assigns the names Option1 and Option2 to the new branches. You should use the more descriptive names Buy Property and Do Nothing. To make this change, click on the text Option1 that appears in the tree and then type Buy Property followed by the ENTER key. Repeat this process to rename Option2 to Do Nothing.
Buy Property 0 Unevaluated Do Nothing 0 Unevaluated

Root 0 Unevaluated

Note that you do not need to edit formulas in the Formula Bar. When building decision trees you create new branches by double-clicking a branch symbol (circle, square, or triangle). And, you enter all input information by editing directly in the tree. Studio builds the required formulas for you automatically. When you click on a node field, such as the node name, a dotted line appears around the field. If you simply begin typing, the entire field is replaced with the new text you type. However, if you click again on the field, it will turn into an edit box where you can change the existing field contents. Clicking outside the field completes the edit.

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NOTE: Do not double-click on a field to begin editing. Instead, click twice. Double-clicking will cause the tree to page into the branch you selected. This will all make sense with a little practice. In this example, you have only two options from which to choose. However, if there were a third option, you could add a third branch by double-clicking on the square following Root. Each time you doubleclick on any branch symbol (circle, square, or triangle), a new branch is added. You can go ahead and try this if you likejust click Undo to remove the branch when you are done. If you buy the property, you will spend $200,000. To reflect this in the tree, click on the zero in the Buy Property branch and enter -200000. Note that the incremental value you enter here is negative because it is a cash outflow.
Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated

Root 0 Unevaluated

The Do Nothing branch is complete. If you buy the property, you will next need to apply for a zoning change. To reflect this in the model, double-click on the triangle following Buy Property and click Pass Through in the Insert Branch dialog box.
Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated Ins1 0 Unevaluated

Root 0 Unevaluated

As you probably expected, this inserted a new branch but its name and incremental value need to be corrected as follows:
Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated Request Rezone -5000 Unevaluated

Root 0 Unevaluated

The problem states that there is a 60% chance that the rezone request will be approved. Therefore, there is also a 40% chance that it will be denied. You reflect this situation in your tree by inserting an event node. Again, double-click on the triangle following Request Rezone and click Event Node in the Insert Branch dialog box.
50% Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated Request Rezone -5000 Unevaluated 50% Outcome1 0 Unevaluated Outcome2 0 Unevaluated

Root 0 Unevaluated

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Just as before, edit the tree to include meaningful names. You also need to change the probabilities on the Approved and Denied branches from 50%/50% to 60%/40%.
60% Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated Request Rezone -5000 Unevaluated 40% Approved 0 Unevaluated Denied 0 Unevaluated

Root 0 Unevaluated

If the rezone request is approved, you will sell the property for $250,000. You can show this in the tree by inserting a pass through node after Approved and enter an incremental value of 250000.
60% Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated Request Rezone -5000 Unevaluated 40% Approved 0 Unevaluated Denied 0 Unevaluated Sell Property 250000 Unevaluated

Root 0 Unevaluated

If the rezone request is denied you have a decision to makeappeal the zoning boards decision (which costs $5,000) or just dump the property for $170,000. Show this in the tree by inserting a decision node following Denied.
60% Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated Request Rezone -5000 Unevaluated 40% Denied 0 Unevaluated Approved 0 Unevaluated Sell Property 250000 Unevaluated Appeal -5000 Unevaluated Dump Property 170000 Unevaluated

Root 0 Unevaluated

The problem states that the appeal has only a 10% chance of success. Model this chance by inserting an event node after appeal.
60% Approved 0 Unevaluated Sell Property 250000 Unevaluated Succeeds 0 Unevaluated Fails 0 Unevaluated

Root 0 Unevaluated

Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated

Request Rezone -5000 Unevaluated Denied 0 Unevaluated

10% Appeal -5000 Unevaluated 90% Dump Property 170000 Unevaluated

40%

If the appeal succeeds, you will sell the property for $250,000; and, if it fails, you will dump the property for $170,000. Note that you cannot use the node names Sell Property and Dump Property because they have already been used. A common way to get around name conflicts is to append a number to each name. For example, Sell Property 1, Sell Property 2, etc. This tree uses the names Sell and Dump.

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60%

Approved 0 Unevaluated

Sell Property 250000 Unevaluated Succeeds 0 Unevaluated Fails 0 Unevaluated Sell 250000 Unevaluated Dump 170000 Unevaluated

Root 0 Unevaluated

Buy Property -200000 Unevaluated Do Nothing 0 Unevaluated

Request Rezone -5000 Unevaluated Denied 0 Unevaluated

10% Appeal -5000 Unevaluated 90% Dump Property 170000 Unevaluated

40%

Calculating a Solution
To calculate a solution to this problem, press the F9 key or click on the Run toolbar button . Once you have calculated a solution, you might want to set number formats by pointing to Node in the Format menu and clicking Properties .
60% Approved 0 $45,000 Sell Property 250000 $45,000 Succeeds 0 $40,000 Fails 0 ($40,000) Sell 250000 $40,000 Dump 170000 ($40,000)

Root 0 $14,200

Buy Property -200000 $14,200 Do Nothing 0 $0

Request Rezone -5000 $14,200 Denied 0 ($32,000)

10% Appeal -5000 ($32,000) 90% Dump Property 170000 ($35,000)

40%

The values at the end nodes are the actual profit or loss that you will experience if you wind up at each node. For example, if you choose to buy the property, request a rezone, the request is approved, and you sell the property, you will earn $45000 (-200000 + -5000 + 0 + 250000). Studio calculates the end node values by accumulating all incremental values between Root and each end node. After calculating the end node values, Studio folds-back the tree to calculate EMVs for each node.

Interpreting Your Results

The final step is to interpret the results of the decision tree analysis. Buying the property has an expected value of $14,200 vs. $0 for doing nothing. Therefore, if you are not adverse to risk, you should purchase the property. Furthermore, if your rezone request is denied, you should appeal. Keep in mind that you can never earn $14,200 on this investment; you will either earn $45,000, $40,000, or lose $40,000. The expected value calculation implicitly assumes that you are not adverse to risk. That is, individual gains or losses on investments like this are of no consequence to you. This is true if you have a large

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amount of money and many investment opportunities. In other cases, though, you should consider the range of outcomes as well as the expected values when interpreting your results. Techniques for applying risk aversion are presented later in this Users Guide.

Choosing Event Probabilities

One important difference between the real estate example and the coin toss example, previously used in Decision Tree Basics, is where the event probabilities came from. When you flip a coin, you know precisely what the possible outcome probabilities are50% heads and 50% tails. However, in the real estate example, the probabilities are only estimates. We have assumed that there is a 60% chance that the rezone request will be approved. Another person constructing the same model might come up with a different estimate. Flipping a coin is truly a random event. That is, each time you repeat the event you might get a different outcome. However, no matter how many times you issue the rezone request, you should get the same result (in theory). The probabilities you assign to this event represent your confidence in predicting an outcome rather than the probability of the outcome occurring. This distinction is not something you should be concerned about. Decision trees help you choose the best option given whatever information you have. It is perfectly valid to use estimated outcome probabilities as in the real estate example.

Inventory Example
Assume you own a sporting goods store in a small community whose local college basketball team has made it into the finals of the national championships. You are sure that if the local team wins you will be able to sell a significant number of T-shirts proclaiming the school as the national champion. Unfortunately, to have the shirts ready the day after the championship game, you will have to order the shirts at least a week in advancebefore you know if the local team will win. You expect to sell between 2,000 and 10,000 shirts at $20 each. You can order the shirts for $7 each. Any shirts you do not sell you can sell as scrap for $2 each. In addition, you estimate that there is a 60% chance of the local team winning. You must decide today if you will order any shirts, and if so, how many. In this problem you face two uncertain events, you don't know who will win the championship game, and you don't know how many shirts you can sell even if the local team does win.

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Here is a decision tree constructed to solve the T-shirt problem:

Demand 3K 25% 3000*20+2000*2 $29,000 Demand 5K 5000*20 $65,000 Demand 7K 5000*20 $65,000 Demand 9K 5000*20 $65,000

25% Team Wins 0 60% $56,000 25% Buy 5K Shirts 5000*-7 $23,600 Team Loses 5000*2 ($25,000)

25%

40%

Demand 3K 1 25% 3000*20+7000*2 $4,000 Demand 5K 1 25% 5000*20+5000*2 $40,000 Demand 7K 1 25% 7000*20+3000*2 $76,000 Demand 9K 1 25% 9000*20+1000*2 $112,000

Root 0 $23,600

60%

Team Wins 1 0 $58,000

Buy 10K Shirts 10000*-7 $14,800 Do Nothing 0 $0 Team Loses 1 10000*2 ($50,000)

40%

In the first node you face a decision. You must decide how many shirts to order. This example has been simplified by assuming you can only order in quantities of 5,000. This means you must order 5,000, 10,000, or none at all. Once you have made a decision about how many shirts to order, you next come to an event nodethe local team either wins or loses the championship. If the team loses, you must sell all of the shirts as scrap losing either $25,000 if you order 5,000 shirts ($2*5,000-$7*5,000) or $50,000 if you order 10,000 shirts ($2*10,000-$7*10,000). If the team wins, you face another uncertaintythe demand for shirts. The problem states that you expect demand to be between 2,000 and 10,000 shirts. A continuous uncertainty, like forecasting sales, can be modeled using several techniques. The simplest technique is to use three to five scenarios and assign a probability to each. In the T-shirt example the range of expected demand was divided into four bands (2-4K, 4-6K, 6-8K, and 8-10K) and the midpoint in each band (3K,5K,7K,9K) is chosen as the scenario's demand. Of course, you cannot sell more shirts than you have. Therefore, if you order only 5,000 shirts, you will make the same profit if demand is 5,000, 7,000 or 9,000. All shirts you have in excess of demand can be sold as scrap. The solution indicated by this tree is that you should order 5,000 shirts because this option yields the highest expected value.

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Editing Node Formulas

Decision trees are a unique type of model in Studio because you dont have to enter a formula in the Formula Bar. Instead, Studio builds the formulas for you automatically. Despite this fact, there are times when you will want to edit the formulas directly. For example, if you want to change the order in which branches are drawn. Decision trees contain four node types: decision, event, pass through, and end. Each is described below.

Decision Nodes
Decision nodes are constructed using the following formula: NodeName := IncValue -> max( Option1, Option2 ,... ) For example, the root node in the real estate example looks like this:
Root:=0->max(Buy Property,Do Nothing)

You can have any number of options listed in the max statement. The order in which the options are listed controls the order in which the branches are drawn.

Event Nodes
Event nodes have the following format: NodeName := IncValue -> emv( P1, Outcome1, P2, Outcome2, ... ) For example, the node Request Rezone is defined as
Request Rezone:=-5000->emv(60%,Approved,40%,Denied)

Arguments in the emv statement are always supplied in pairs. The first argument in the pair is the branch probability and the second argument is the branch name.

Pass Through Nodes

Pass through nodes have the format NodeName := IncValue -> ( NextNodeName ) For example,
Buy Property:=-200000->(Request Rezone)

End Nodes
End nodes simply contain an incremental value using the syntax NodeName := IncValue -> For example,
Sell Property:=250000->

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Chapter 3

Decision Trees with Discounted Cash Flows

Usually, when you build a decision tree, you assume that all events take place close enough together that time value of money is not important. However, to be precise, you should replace each incremental value with a present value. The easiest way to do this is to create your own discounting function and use it in each incremental value entry. Lets modify the real estate tree to discount all cash flows by 7% per year. Furthermore, lets assume you purchase the property in year zero, and each rezone request takes a year. This means you can sell the property in year one or two depending on if you appeal the zoning boards decision. You start with the following decision tree:
60% Approved 0 $45,000 Sell Property 250000 $45,000 Succeeds 0 $40,000 Fails 0 ($40,000) Sell 250000 $40,000 Dump 170000 ($40,000)

Root 0 $14,200

Buy Property -200000 $14,200 Do Nothing 0 $0

Request Rezone -5000 $14,200 Denied 0 ($32,000)

10% Appeal -5000 ($32,000) 90% Dump Property 170000 ($35,000)

40%

The first thing you will do is edit the -200000 in the Buy Property node and replace it with Pv(-200000,0). Pv is a function that will be created later. It takes two arguments, the cash flow amount and the year you encounter the cash flow.
Pv -Undefined Request Rezone -5000 $14,200 Denied 0 ($32,000) 60% Approved 0 $45,000 Sell Property 250000 $45,000 Succeeds 0 $40,000 Fails 0 ($40,000) Sell 250000 $40,000 Dump 170000 ($40,000)

Root 0 $14,200

Buy Property Pv(-200000,0) $14,200 Do Nothing 0 $0

10% Appeal -5000 ($32,000) 90% Dump Property 170000 ($35,000)

40%

Note that Pv now shows up as an undefined node. Select this node and enter the following formula:
Pv(cash,year):=cash/(1+Int)^year

Also, enter the following definition for the discount rate:

Int:=7%

With a little formatting change on the nodes Pv and Int, the tree now looks like this:

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Pv( cash, year ) :=

cash
year

( 1 + Int ) Function Buy Property Pv(-200000,0) $14,200 Do Nothing 0 $0 Request Rezone -5000 $14,200

Int := 7% 7% Sell Property 250000 $45,000 Succeeds 0 $40,000 Fails 0 ($40,000) Sell 250000 $40,000 Dump 170000 ($40,000)

60%

Root 0 $14,200

Approved 0 $45,000

10% Appeal -5000 ($32,000) 90% Dump Property 170000 ($35,000)

40%

Denied 0 ($32,000)

Since you dont want the node Pv showing up every place you use it, you should make it a hidden node. To do this, select Pv and then point to Node in the Format menu and click Hide Node. If you later want to display Pv so that you can change it, just point to Node in the Format menu and click Show Hidden Nodes. After hiding Pv and using it in every incremental cash flow, you get the following tree:
60% Approved 0 $28,645 Sell Property Pv(250000,1) $28,645 Succeeds 0 $8,687 Fails 0 ($61,188) Sell Pv(250000,2) $8,687 Dump Pv(170000,2) ($61,188)

Root 0 $0

Buy Property Pv(-200000,0) ($1,262) Do Nothing 0 $0

Request Rezone Pv(-5000,0) ($1,262) Denied 0 ($46,121)

10% Appeal Pv(-5000,1) ($54,201) 90% Dump Property Pv(170000,1) ($46,121)

40%

One interesting thing to note is that applying time value of money to the real estate example changed the outcome values enough that now the best option is to do nothing. This example uses a custom function to calculate present values. Using a custom function instead of a built in function allows you to enter the discount rate in the definition of Pv rather than have to include it in each incremental value. Building your own discounting function also gives you the opportunity to specify input data in any way you like. For example, instead of using the year values 0, 1, 2, etc., suppose you want to enter actual years such as 2002, 2003, 2004, etc. You can do this simply by changing the definition of Pv from
Pv(cash,year):=cash/(1+Int)^year

to
Pv(cash,year):=cash/(1+Int)^(year-2002)

This will discount all values back to the year 2002. The following possible definition for Pv uses the npv function which accepts a list of annual cash flow values:
Pv(...):=npv(Int,arguments)

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Chapter 3

With this definition, an expression such as Pv(0,-100,-50) means there is a cash outflow of 100 and 50 in years one and two respectively. You are free to choose any definition for Pv that best suits your analysis.

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Analyzing Decision Trees

Contents
Risk Profile Graphs Break-Even Analysis Value of Perfect Information

The chapter provides insight into communicating risk factors, interpreting results, and refining models to get the results you need.

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Chapter 4

Risk Profile Graphs

Once you have constructed a basic tree to model your decision, you can perform a number of analyses to help you better understand the results and refine your model.

Graphing Risk Factors

A decision tree conveys a great deal of information about your decisions. It presents all of your options, the potential consequences of each option, contingent actions, and outcome values. However, if your tree is large, it is often difficult to appreciate the level of risk you are assuming by choosing a particular option. Keep in mind that the decision trees illustrated so far assume you are completely indifferent to risk. Generating a risk profile graph helps you to understand and communicate the risks involved. In the real estate example discussed previously, you know that going ahead with the project has an expected value of $14,200 vs. $0 if you do nothing. However, going ahead also means that you could lose as much as $40,000 if things don't go well. A risk profile graph shows all of the possible outcomes and their probabilities so that these factors are understood. To construct a risk profile graph, point to Decision Tree in the Tools menu and click Risk Profile Graph. All you need to do is enter the name of the root node in your tree and tell Studio which nodes are terminal Studio automatically creates the appropriate graph.

You get the following graph for the real estate example:
Risk Profile
60% 50% 60%

Probability

40% 30% 20% 10% 0%

36%

-0% ($40,000) ($20,000)

0% $0 $20,000

4%

$40,000

$60,000

Outcome Value

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Analyzing Decision Trees

You can also create a table of outcome values by choosing the Risk Profile Table tool and following the same procedure.
Risk Profile
Outcome Dump Dump Property Do Nothing Sell Sell Property Value ($40,000) ($35,000) $0 $40,000 $45,000 Probability 36.00% -0.00% 0.00% 4.00% 60.00%

Break-Even Analysis
It is often useful to test the assumptions in your model. Suppose you want to know how low your chances of getting the rezone approved must be before you change your decision. To do this, modify your model slightly by changing the definition for Request Rezone from
Request Rezone:=-5000->emv(60%,Approved,40%,Denied)

to
Request Rezone:=-5000->emv(P,Approved,1-P,Denied)

and add the node

P:=60%
P -60% Approved 0 $45,000 Sell Property 250000 $45,000 Succeeds 0 $40,000 Fails 0 ($40,000) Sell 250000 $40,000 Dump 170000 ($40,000)

P Buy Property -200000 $14,200 Do Nothing 0 $0 1-P Request Rezone -5000 $14,200

Root 0 $14,200

10% Appeal -5000 ($32,000) 90% Dump Property 170000 ($35,000)

Denied 0 ($32,000)

Next, use the Goal Seek tool to find the value for P required to make the value of Buy Property equal to zero (this is the value at which you would switch to Do Nothing). The Goal Seek tool is available in the Tools menu.

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Chapter 4

P -42% Approved 0 $45,000 Sell Property 250000 $45,000 Succeeds 0 $40,000 Fails 0 ($40,000) Sell 250000 $40,000 Dump 170000 ($40,000)

P Buy Property -200000 $0 Do Nothing 0 $0 1-P Request Rezone -5000 $0

Root 0 $0

10% Appeal -5000 ($32,000) 90% Dump Property 170000 ($35,000)

Denied 0 ($32,000)

Studio will calculate the required percentage and update your tree. In this case, 42% is the minimum probability of a successful rezone required to go ahead with the project. You can use the same technique to find break-evens for outcome values as well. This information can tell you how sensitive your model is to key assumptions and whether you should spend time refining these assumptions.

Value of Perfect Information

Another way to determine if you should expend resources to refine your model is to use the Value of Perfect Information tool. This tool calculates the value of knowing today what will happen in a future event. Suppose someone knew for certain if your rezone request was going to be approved. What would you be willing to pay for this information?

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Analyzing Decision Trees

To find out, point to Decision Tree in the Tools menu and click Value of Perfect Information. Next, enter the name of the root node in your model and the node you want to value.

Studio will display the result as follows:

What does this result mean? Seldom will you run into a situation where someone can sell you definitive information about what will happen in the future. However, you can generally buy research that will help you come closer to knowing what will happen. Calculating the value of knowing precisely what will happen sets an upper limit on the value of that research. This value helps you determine if you should invest in additional research and the maximum amount you should be willing to pay for it.

How It Works
The Value of Perfect Information tool calculates a result by internally restructuring your tree to reflect a situation where you have perfect information. Then, it compares this to the initial problem.

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Chapter 4

If you could buy information about whether or not the rezone request will be approved, the decision tree would look something like this:
100% Approved 1 0 $45,000 Sell Property 1 250000 $45,000 Succeeds 1 0 $40,000 Fails 1 0 ($40,000) Sell 1 250000 $40,000 Dump 1 170000 ($40,000)

60%

Will be Approved 0 $45,000

Buy Property 1 -200000 $45,000 Do Nothing 1 0 $0

Request Rezone 1 -5000 $45,000 Denied 1 0 ($32,000)

10% Appeal 1 -5000 ($32,000) 90% 0%

Root 0 $27,000

Dump Property 1 170000 ($35,000) Approved 2 0 $45,000 Sell Property 2 250000 $45,000 Succeeds 2 0 $40,000 Fails 2 0 ($40,000) Sell 2 250000 $40,000 Dump 2 170000 ($40,000)

0%

40%

Will be Denied 0 $0

Buy Property 2 -200000 ($32,000) Do Nothing 2 0 $0

Request Rezone 2 -5000 ($32,000) Denied 2 0 100% ($32,000)

10% Appeal 2 -5000 ($32,000) 90%

Dump Property 2 170000 ($35,000)

You don't know at the time you buy the information what it will tell you. But, you already know there is a 60% chance the information will tell you that the rezone will be approved and there is a 40% chance it will be denied. The value of this tree is $27,000, or $12,800 more than the $14,200 value in the original tree. Therefore, the perfect information is worth $12,800.

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C h a p t e r

Risk Aversion
Contents
Assessing Risk Using Risk Aversion

Being able to measure risk in a model that is based on assumptions is a key factor in evaluating your options. This chapter shows how to compensate for the risk that is often inherent in decision tree models.

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Chapter 5

Assessing Risk
Decision trees are based on the assumption that you are indifferent to risk. This assumption is probably true if the amount of money at risk is substantially smaller that the total amount of money available. However, for large sums, the risk component can become important. Consider the following example:
50% Big Outcome 1 $100,002 50% Big Outcome 2 ($100,000) 50% Small Outcome 1 $1 50% Small Outcome 2 ($1)

Option 1 $1 Root $1 Option 2 $0

A simple decision tree analysis shows you that Option 1 has a higher expected value than Option 2. So you should choose Option 1, right? Well, not many people are willing to risk losing $100,000 to gain $1 in expected value. Option 1 is significantly more risky that Option 2. You might be tempted to argue that decision trees are fundamentally flawed. Rest assured that they are not. What is flawed is the notion that your first dollar is worth the same amount as your millionth dollar. This flaw is handled using a concept often referred to as utility.

Utility
Implicit in the decision tree above is the notion that $100,000 is 100,000 times as valuable as $1. This is simply not true. Given a limited amount of money, an individual would spend the first dollar on the item that provides the greatest value for money. The next dollar would be spent on the next most valuable. And so on. The result is that every dollar has slightly less value than the previous dollar. Companies often face the same decreasing value of money. A company generally has available a limited number of projects in which to invest. The projects with the highest returns get the first dollars. The second best projects get the next dollars. And so on. Also, a company's cost of capital (the interest rate paid for money) shows this same non-linear relationship. A company will raise money from the least expensive sources first. To compensate for this effect, you need to replace monetary outcome values with another measure utility.

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Risk Aversion

Utility is simply a measure of the usefulness of an outcome. If you were to plot an individual's perception of utility as a function of money, you would get a curve similar to this:

Utility

Monetary Value

This curve tends to level off as the monetary outcome increases; meaning that each dollar is worth less than the previous. By controlling the shape of the utility curve, you can model a decisionmaker's risk behavior. A downward-cupped curve represents riskadverse behavior. A straight-line represents risk-neutral behavior. And, an upward-cupped curve represents risk-seeking behavior.

Risk Adverse

Risk Neutral

Risk Seeking

Risk-seeking behavior might seem to be a bit ridiculous. However, it is quite common. Just consider how much money is spent gambling in casinos. Mathematically, utility is often implemented using an exponential or logarithmic function. Studio uses the function
U ( x ) = 1 e k*x

where k is a constant reflecting the decision-maker's risk-averse (or riskseeking) behavior, and x is the monetary value. Now lets revisit the real estate decision tree, presented in the Building Decision Trees chapter, and replace all monetary values with utilities. By convention, utility generally ranges from zero (no value) to one (all wealth available to the decision-maker). The actual range and scale of the utility curve are not important. This example will use the function graphed below.

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Chapter 5

1.0

0.8

Utility

0.6

0.4

0.2

0.0 ($100,000) ($50,000) $0 $50,000 $100,000

Monetary Value

Without Utility
Option 1 $1 Root $1 Option 2 $0 50% Big Outcome 1 $100,002 50% Big Outcome 2 ($100,000) 50% Small Outcome 1 $1 50% Small Outcome 2 ($1)

With Utility
Option 1 0.498 Root 0.688 Option 2 0.688 50% Big Outcome 1 0.997 50% Big Outcome 2 0.000 50% Small Outcome 1 0.688 50% Small Outcome 2 0.687

Notice that now the chosen option has switched from Option 1 to Option 2. In fact, the expected value for Option 2 is now significantly higher than that for Option 1. This result is more in keeping with our expectations.

Certainty Equivalents
One problem with using utility rather than monetary value is that it is difficult to understand what the numbers mean and almost impossible to explain them to someone else. However, Studio allows you to apply utility while still viewing your results in terms of dollar equivalents. Consider the following example:
50% Outcome 1 $100,000 50% Outcome 2 $0

Root

Option 1 $50,000 Option 2

What value for Option 2 will make you indifferent between these two options? Lets say that if Option 2 were to receive a certain $40,000, you would be indifferent. In other words, a 50% chance of receiving $100,000 is the same as a certain receipt of $40,000. If this were the case, you would want the decision tree to show the value of Option 1 to be $40,000 rather than $50,000. $40,000 is the risk-adjusted expected monetary value. This value is often called a certainty equivalent. It is a certain amount of money that is equivalent to the uncertain payout. Certainty equivalents and utility are closely related. In fact, it is quite easy to translate values between certainty equivalents and utility. Studio converts dollar quantities to utility values before performing EMV calculations; then it converts the result back to dollars. In this way you

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Risk Aversion

can use the concept of utility to model risk aversion while still working with monetary values. Applying a high level of risk aversion to the example creates a decision tree that looks like this:
Option 1 ($35,375) Root ($0) Option 2 ($0) Values are risk-adjusted 50% Big Outcome 1 $100,002 50% Big Outcome 2 ($100,000) 50% Small Outcome 1 $1 50% Small Outcome 2 ($1)

Note that a 50% chance of earning $100,002 combined with a 50% chance of losing $100,000 is now worth negative $35,375 rather than $1 as before. You can control what this value will be by setting the level of risk aversion. Studio then consistently applies that level of aversion to all parts of the tree. Earlier, in the Decision Tree Analysis chapter, we stated that EMV is calculated using the equation
EMV = Valuen Probabilityn
n =1 N

With utility, the actual equation is

EMV = U 1 [ U ( Valuen ) Probabilityn ]
n =1 N

where U(x) is the utility function. This calculation is carried out by the emv primitive.

Using Risk Aversion

By now you might be starting to think that risk aversion is more trouble than it is worth. Actually, it is quite easy to use in Studio. First, construct your decision tree as usual. Next, point to Decision Tree in the Tools menu and click Set Risk Aversion (Utility) and follow the instructions in the dialog box.

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Chapter 5

After you have selected a level of risk aversion that seems to match your appetite for risk, based on the sample problem in the dialog box, click OK to return to your decision tree. Calculate a solution for your decision tree, and look at the event nodes in your tree to see if the certainty equivalents calculated for each node make sense to you. If they don't, go back to the Risk Aversion tool and make fine adjustments. Once you have set the risk aversion for a model, you don't need to adjust it as you modify your model. Studio will use the level of risk aversion you have set as a guide and apply a consistent level of aversion to all parts of your tree. Risk aversion is implemented entirely in the emv primitive and only affects calculation involving that primitive.

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C h a p t e r

Markov Simulation
Contents
Markov Models

Markov Simulations are used to predict how dynamic systems behave over time. Using examples, this chapter describes how to build, graph, and analyze Markov models.

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Chapter 6

Markov Models
Markov models are very different from the expected value-based decision trees illustrated previously. For example, the decision tree models are static. That is, each time you press F9 or click the Run button to recalculate, you get the same solution. Markov models are dynamic. Each time you recalculate, the solution changes in a predictable way. Assume you have two buckets. The first bucket contains 100 marbles and the second bucket contains none. Every minute you take half of the marbles in the first bucket and put them in the second bucket. This is a Markov system. You know that the initial state of the system is 100 marbles in bucket one and none in bucket two. You also know that if you let the system run long enough, all of the marbles will be in the second bucket. However, what is more interesting is what happens in the intervening stages, which is what the Markov simulation tells you.

Community Health Example

Assume you have a community of 100 people. Initially, 83 of the people are healthy and 17 are sick. You predict that each year 20% of the healthy people will get sick. Furthermore, 25% of the sick people will die and the remainder will get better. You want to know how many people will still be alive after 10, 20, 30, years.

Building a Markov Model

The first step in building a model to solve this problem is to choose New in the File menu and click Markov Model. This brings up the following model template:
Reset Single Step 50% State1 Circular 50% State2 Unevaluated

Root Unevaluated

1 State1 Unevaluated 0 State2 Unevaluated

At any particular time, a person can be in one of three states: Healthy, Sick, or Deceased. Since the template has two states defined, doubleclick on the circle following Root to add a new state node. Like decision tree models, Markov models can be built largely by double-clicking branch symbols (circle, square, or triangle) to add new branches, and editing nodes directly in the tree.

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Markov Simulation

1 State1 Unevaluated Root Unevaluated 0 State2 Unevaluated 0 State3 Unevaluated

50% State1 Circular 50% State2 Unevaluated

Next, rename the state nodes to Healthy, Sick, and Deceased.

50% Healthy Circular 50% Sick Unevaluated

1 Healthy Unevaluated Root Unevaluated 0 Sick Unevaluated 0 Deceased Unevaluated

You also know that you start out with 83 people in the Healthy state, 17 people in the Sick state, and no people in the Deceased state. You reflect this in the model by editing the numbers following Root.
50% Healthy Circular 50% Sick Unevaluated

83 Healthy Unevaluated Root Unevaluated 17 Sick Unevaluated 0 Deceased Unevaluated

If a person is healthy, you know that there is an 80% chance that they will remain healthy and a 20% chance that they will become sick. You can show this in the tree by editing the percents following Healthy:
80% Healthy Circular 20% Sick Unevaluated

83 Healthy Unevaluated Root Unevaluated 17 Sick Unevaluated 0 Deceased Unevaluated

If a person is sick, there is a 25% chance that they will die and a 75% chance that they will return to the Healthy state. To reflect this in the model, edit Sick as follows:
Sick:=mkv(75%,Healthy,25%,Deceased)
80% Healthy Circular 20% Sick Unevaluated

83 Healthy Unevaluated Root Unevaluated 17 Sick Unevaluated 0 Deceased Unevaluated

75% Healthy Circular 25% Deceased Unevaluated

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Chapter 6

The model is now complete. To start the Community Health model, click on the Reset button. This will cause the tree to show the following state information:
80% Healthy Circular 83 Healthy 83 Root null 17 Sick 17 0 Deceased 0 20% Sick 17 75% Healthy Circular 25% Deceased 0

This is the initial stagethere are 83 healthy people and 17 sick people. Click Single Step or the Run button to progress to the next stage.

80% Healthy Circular 83 Healthy 79.15 Root null 17 Sick 16.6 0 Deceased 4.25 20% Sick 16.6 75% Healthy Circular 25% Deceased 4.25

Click again to progress to the third stage.

80% Healthy Circular 83 Healthy 75.77 Root null 20% Sick 15.83 75% Healthy Circular 25% Deceased 8.4

17 Sick 15.83 0 Deceased 8.4

Each time you click Single Step, the model progresses one more stage. Eventually, all of the people will be in the Deceased state. Note that even though you can never have a fraction of a person in one state, the Markov model does not round values to the nearest integer.

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State Graphs
Instead of viewing the model after each step, it is often more valuable to view a graph showing the number of people in each state over a range of time. To do this, point to Markov in the Tools menu and click State Graph. This will bring up the following dialog box:

Change the State node(s) field to include a list of all states you want to graph. Also, enter the stage numbers you want to plot. Stage 0 is the initial stage (100 healthy people) and stage 1 is the state after the Single Step button is clicked once. After clicking OK, you will get the following graph:
Markov State Graph
100

80

Value

60

40

20

0 0 20 40 60 80

Stage Number
Healthy Sick Dead

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Clicking State Table instead of State Graph will give you a table of state values:
Markov State Table
Value
Healthy 0 1 2 3 4 5 6 7 83 79.15 75.77 72.49 69.36 66.36 63.49 60.75 58.12 55.61 53.2 50.9 48.7 46.6 44.59 42.66 40.81 39.05 37.36 35.75 34.2 Sick 17 16.6 15.83 15.15 14.5 13.87 13.27 12.7 12.15 11.62 11.12 10.64 10.18 9.74 9.32 8.92 8.53 8.16 7.81 7.47 7.15 Dead 0 4.25 8.4 12.36 16.15 19.77 23.24 26.56 29.73 32.77 35.67 38.45 41.11 43.66 46.1 48.43 50.65 52.79 54.83 56.78 58.65

Stage Number

8 9 10 11 12 13 14 15 16 17 18 19 20

Health Insurance Pool Example

Let's complicate the Community Health example a bit by making the model more accurate and use it to calculate how much it will cost to provide medical coverage for a pool of 100 people. Just as in the Community Health model, 20% of the healthy people become sick in any given year. However, you have observed that young people tend to be more likely to recover than do old people. So, rather than assume 25% of all sick people die, you will use the following equation to represent the probability of dying:
P=1.0035^Age-1

To simplify the application of this equation, assume that all 100 people are newborns. That way, everyone is always the same age and their age is the same as the stage number.
80% Healthy Circular 83 Healthy 83.34 Root 17 Sick 16.6 0 Deceased 0.06 20% Sick 16.6 Probability of death P := 1.0035 0.35% 1-P Healthy Circular P Deceased 0.06
Stage

-1

Stage := Stage + 1 1

Stage Circular

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Markov Simulation

The results for this model will be similar to those for the Community Health model. However, one of the probabilities is variable. Now, let's assume that health coverage costs $500 per year for each healthy person and $4,000 for each sick person. You can reflect this in the model by creating a new root node with the definition
Annual Cost:=(Root,500*Healthy+4000*Sick)

Annual Cost performs two steps: First, it evaluates Root, causing the Markov model to progress to the next stage; then, it uses the results of the stage simulation to calculate the medical costs for that year. What you really want to know is the Net Present Value (NPV) of costs over all stages. To do this you need to add two additional nodes as follows:
Present Value:=npv(10%,Cash Flow) Cash Flow:=(clear,makelist((reset,Annual Cost),n,0,100))

Cash Flow resets the model (clear) then evaluates Annual Cost 101 times. This results in a list of 101 cash flow values. Finally, Present Value performs a simple NPV calculation.
Root Present Value:=npv(10%,Cash Flow) $1,127,925.82 Cash Flow:=(clear,makelist((reset,Annual Cost),n,0,10 [109500,108070,108250,108033,107819,107529,1071 Annual Cost:=(Root,Healthy*500+Sick*4000) $3,259.21 Healthy 2.39 Sick 0.52

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Chapter 6

40 Vanguard Decision Tree Analysis Add-in User's Guide

Index

Index
Add-in, finding and starting, 3 Analysis break-even, 23 risk profiles, 22 Assessing risk, 28 Break-even analysis, 23 Building decision trees, 10 Building Markov models, 34 Calculating solutions, 14 Certainty equivalents, 30 Choosing event probabilities, 15 Decision nodes, 7, 17 Decision tree analysis add-in, overview, 2 Decision tree examples community health (markov), 34 health insurance pool (markov), 38 inventory, 15 real estate, 10 Decision tree templates, 10 Decision trees about, 6 decision diagrams, 7 expected monetary value, 6 incremental values, 8 Discounted cash flows, 18 Editing node formulas, 17 End nodes, 17 Event nodes, 7, 17 Event probabilities choosing, 15 example, 15 Examples community health (markov), 34 health insurance pool (markov), 38 inventory, 15 real estate, 10 Expected monetary value, 6 Goal seek tool, 23 Graphing risk factors, 22 Installation instructions, 2 Interpreting results, 14 Markov simulations about, 34 building, 34 community health model, 34 health insurance pool model, 38 state graphs, 37 tool, 37 Node formulas decision nodes, 17 editing, 17 end nodes, 17 event nodes, 17 pass through nodes, 17 Pass through nodes, 17 Results, interpreting, 14 Risk aversion about, 28 certainty equivalents and, 30 tool, 31 using, 31 utility concept, 28 Risk profile tool, 22 Studio, starting, 3 System requirements, 2 Templates, using, 10 Tools build wizard, 10 goal seek, 23 Markov, 37 risk aversion, 31 risk profile, 22 value of perfect information, 24 Utility, 28 Value of perfect information about, 24 how it works, 25 tool, 24 Wizard templates, 10

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