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Decision Trees

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What is a Decision Tree?

Decision Tree
Decision Tree

A Visual Representation of Choices, Consequences, Probabilities, and Opportunities.

A Way of Breaking Down Complicated Situations Down

to Easier-to-Understand

Scenarios.

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http://www.bized.co.uk Easy Example • A Decision Tree with two choices. Go to Graduate School to get

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Easy Example

A Decision Tree with two choices.

Go to Graduate School to

get my master in CS.

http://www.bized.co.uk Easy Example • A Decision Tree with two choices. Go to Graduate School to get

Go to Work “in the Real World”

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Notation Used in Decision Trees

http://www.bized.co.uk Notation Used in Decision Trees • A box is used to show a choice that

A box

is used to show a choice

that the manager has to make.

A circle

http://www.bized.co.uk Notation Used in Decision Trees • A box is used to show a choice that

is used to show that a

probability outcome will occur.

Lines

http://www.bized.co.uk Notation Used in Decision Trees • A box is used to show a choice that

connect outcomes to their

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Example Decision Tree

Chance

node
node

Decision

http://www.bized.co.uk Example Decision Tree Chance node Decision node Event 1 Event 2 Event 3 Copyright 2006

node

http://www.bized.co.uk Example Decision Tree Chance node Decision node Event 1 Event 2 Event 3 Copyright 2006

Event 1

Event 2

Event 3

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Decision Trees

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Planning Tool

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Decision Trees

Enable a business to quantify decision making

Useful when the outcomes are uncertain

Places a numerical value on likely or potential outcomes

Allows comparison of different possible decisions to be made

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Decision Trees

Limitations:

How accurate is the data used in the construction of the tree?

How reliable are the estimates of the probabilities?

Data may be historical does this data relate to real time?

Necessity of factoring in the qualitative factors human resources, motivation, reaction, relations with suppliers and other stakeholders

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Process

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Process http://www.bized.co.uk Copyright 2006 – Biz/ed

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The Process

Economic growth rises

Expected outcome

http://www.bized.co.uk The Process Economic growth rises Expected outcome 0.7 £300,000 Expand by opening new outlet Economic
  • 0.7 £300,000

Expand by opening new outlet

Economic growth declines

Expected outcome

-£500,000
0.3

Maintain current status

£0

The circle denotes the point where different outcomes could occur. The estimates of the probability and the

 

knowledge of the expected outcome allow the firm to make a calculation of the likely return. In this example

A square denotes the point where a decision is made, In this example, a business is contemplating

 

it is:

There is also the option to do nothing and maintain the current status quo! This would have an outcome of

opening a new outlet. The uncertainty is the state of the economy if the economy continues to grow

Economic growth rises: 0.7 x £300,000 = £210,000

£0.

healthily the option is estimated to yield profits of £300,000. However, if the economy fails to grow as

 

expected, the potential loss is estimated at £500,000.

Economic growth declines: 0.3 x £500,000 = -£150,000

 

The calculation would suggest it is wise to go ahead with the decision ( a net ‘benefit’ figure of +£60,000)

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The Process

Economic growth rises

Expected outcome

http://www.bized.co.uk The Process Economic growth rises Expected outcome 0.5 £300,000 Expand by opening new outlet Economic
  • 0.5 £300,000

Expand by opening new outlet

Economic growth declines

Expected outcome

-£500,000
0.5

Maintain current status

£0

Look what happens however if the probabilities change. If the firm is unsure of the potential for growth, it might

estimate it at 50:50. In this case the outcomes will be:

Economic growth rises: 0.5 x £300,000 = £150,000

Economic growth declines: 0.5 x -£500,000 = -£250,000

In this instance, the net benefit is -£100,000 the decision looks less favourable!

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Advantages

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Disadvantages

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http://www.bized.co.uk Example – Joe’s Garage Joe’s garage is considering hiring another mechanic. The mechanic would cost

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Example – Joe’s Garage

Joe’s garage is considering hiring another mechanic. The

mechanic would cost them an additional $50,000 / year in salary and benefits. If there are a lot of accidents in Iowa City this year,

they anticipate making an additional $75,000 in net revenue. If there are not a lot of accidents, they could lose $20,000 off of

last year’s total net revenues. Because of all the ice on the roads, Joe thinks that there will be a 70% chance of “a lot of accidents” and a 30% chance of “fewer accidents”. Assume if he doesn’t

expand he will have the same revenue as last year.

Draw a decision tree for Joe and tell him what he should do.

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http://www.bized.co.uk Example - Answer 70% chance of an increase in accidents Hire new mechanic Cost =

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Example - Answer

70% chance of an increase in

http://www.bized.co.uk Example - Answer 70% chance of an increase in accidents Hire new mechanic Cost =

accidents

http://www.bized.co.uk Example - Answer 70% chance of an increase in accidents Hire new mechanic Cost =

Hire new mechanic

Cost = $50,000

  • Profit = $70,000

30% chance of a decrease in accidents

Profit = - $20,000

Don’t hire new

mechanic Cost = $0

• Estimated value of “Hire Mechanic” =

NPV =.7(70,000) + .3(- $20,000) - $50,000 = - $7,000

Therefore you should not hire the mechanic

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Problem: Jenny Lind

Jenny Lind is a writer of romance novels. A movie company and a TV network both

want exclusive rights to one of her more

popular works. If she signs with the network, she will receive a single lump sum, but if she signs with the movie

company, the amount she will receive depends on the market response to her movie. What should she do?

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Payouts and Probabilities

Movie company Payouts

Small box office - $200,000 Medium box office - $1,000,000 Large box office - $3,000,000

TV Network Payout

Flat rate - $900,000

Probabilities

P(Small Box Office) = 0.3

P(Medium Box Office) = 0.6

P(Large Box Office) = 0.1

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Jenny Lind - Payoff Table

   

States of Nature

Decisions

Small Box Office

Medium Box Office

Large Box Office

Sign with Movie Company

$200,000

$1,000,000

$3,000,000

Sign with TV Network

$900,000

$900,000

$900,000

Prior

     

Probabilities

0.3

0.6

0.1

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Jenny Lind Decision Tree

Small Box Office Medium Box Office Large Box Office Small Box Office Medium Box Office Large
Small Box Office
Medium Box Office
Large Box Office
Small Box Office
Medium Box Office
Large Box Office
$200,000
Sign with Movie Co.
$1,000,000
$3,000,000
$900,000
Sign with TV Network
$900,000
$900,000

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Jenny Lind Decision Tree

ER

?

Small Box Office ER $200,000 .3 ? Sign with Movie Co. Medium Box Office .6 $1,000,000
Small Box Office
ER
$200,000
.3
?
Sign with Movie Co.
Medium Box Office
.6
$1,000,000
.1
Large Box Office
$3,000,000
Small Box Office
ER
$900,000
.3
?
Sign with TV Network
Medium Box Office
.6
$900,000
.1
Large Box Office
$900,000

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Jenny Lind Decision Tree -

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Solved

Small Box Office ER .3 960,000 Sign with Movie Co. Medium Box Office .6 .1 Large
Small Box Office
ER
.3
960,000
Sign with Movie Co.
Medium Box Office
.6
.1
Large Box Office
ER Sign with TV Network
ER
Sign with TV Network
Small Box Office .3 Medium Box Office .6 .1 Large Box Office
Small Box Office
.3
Medium Box Office
.6
.1
Large Box Office

900,000

ER

960,000

$200,000

$1,000,000

$3,000,000

$900,000

$900,000

$900,000

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Mary’s Factory

Mary is the CEO of a gadget factory.

She is wondering whether or not it is a good idea to expand her

factory this year. The cost to expand her factory is $1.5M. If she

expands the factory, she expects to receive $6M if economy is good and people continue to buy lots of gadgets, and $2M if economy is bad.

If she does nothing and the economy stays good she expects $3M in

revenue; while only $1M if the economy is bad.

She also assumes that there is a 40% chance of a good economy and

a 60% chance of a bad economy.

Draw a Decision Tree showing these choices.

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http://www.bized.co.uk Decision Tree Example Expand Factory Cost = $1.5 M 40 % Chance of a Good

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Decision Tree Example

http://www.bized.co.uk Decision Tree Example Expand Factory Cost = $1.5 M 40 % Chance of a Good

Expand Factory

Cost = $1.5 M

http://www.bized.co.uk Decision Tree Example Expand Factory Cost = $1.5 M 40 % Chance of a Good

40 % Chance of a Good Economy

Profit = $6M

60% Chance Bad Economy

Profit = $2M

Don’t Expand Factory

Cost = $0

http://www.bized.co.uk Decision Tree Example Expand Factory Cost = $1.5 M 40 % Chance of a Good

Good Economy (40%)

Profit = $3M

Bad Economy (60%)

Profit = $1M

EV Expand = (.4(6) + .6(2)) 1.5 = $2.1M

EV No Expand = .4(3) + .6(1) = $1.8M

$2.1 > 1.8, therefore you should expand the factory

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Mary’s Factory –

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Discounting

Before Mary takes this to the board, she wants to account for

the time value of money. The gadget company uses a 10% discount rate (interest). The cost of expanding the factory is paid in year zero but the revenue streams are in year one.

Compute the NPV again, this time accounts the time value of money in your analysis. Should she expand the factory?

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