Decision Trees

In a capital budgeting exercise, the decision-maker has to identify

and evaluate the various alternative courses of action leading to the
investment decision. A decision tree captures these alternatives in
form of a diagram and is useful for clarifying the range of alternative
course of action, assessing possible outcomes.
In a statistical sense, when a sequential series of conditional
decisions are required to be taken under conditions of uncertainty,
decision tree model comes in handy to visualize and evaluate all
possible options for action.
Consider this example. The purchase of an asset could lead to an
increase in sales. This increase can either be low, medium or high
with probabilities of 0.5, 0.3 and 0.2 respectively. Each of these could
be referred to as a branch and may yield differing contributions and
fixed costs, and in turn to differing profit levels giving rise to various
outcomes. Such possibilities are captured in decision tree.
There are two stages in preparing decision tree. The first step is
drawing the decision tree itself, in a manner that reflects all
outcomes and choices. The second step is to incorporate
probabilities, relevant values and derive expected monetary values.
Rules for drawing a decision tree diagram
Some basic rules in drawing the decision tree are:
Rule 1 : A decision tree begins with a decision point. A decision point
( also known as node) is represented by a rectangle. An outcome
point (also known as chance node) is denoted in circle.
Rule 2 : Decision alternatives (e.g. sales volume in the preceding
example) are shown by a straight line originating from decision node.
Rule 3 : A decision tree diagram is drawn from left to right. The
rectangles and circles are sequentially numbered.
Rule 4 : Values and probabilities for each branch are then
incorporated.

Evaluation and decision rules

A decision tree is analyzed and evaluated using toll-back method.
That is the value of each circle and each square is computed by
evaluating from right to left. This technique proceeds from last
decision in the sequence, wand works back to the first, for each of
the possible decisions. There are two rules in this evaluation.
Rule 1 : The expected monetary value at a chance node (branches
emanating from a circle) is aggregate of the expected values of the
various branches and emanate from the chance node.
Rule 2 : The expected value at a decision node (branches emanating
from a square) is the highest amongst the expected values of the
various branches that emanate from the decision node.
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