# Decision Trees

Note taking for the Objectives and Strategy Topic

- Created by: Emma Rudd
- Created on: 19-06-08 15:27

First 470 words of the document:

Objectives and Strategy Decision Trees Emma Rudd BMA

A decision tree is a mathematical model which can be used by managers to help them make

the right decision.

A square shows a decision has to be made; the lines coming from it show the possible

choices and the circles show that different outcomes are possible, which is then

illustrated by lines coming from the circles. Managers always have the option of doing

nothing so this always has to be an option on a decision tree. The probability of each

outcome needs to be known, the value ranging from 0 to 1, the bigger the number the more

likely it is to happen.

A diagram should include;

Possible decisions a firm could take

The outcomes of each decisions

The probability of each outcome

The financial consequences of each outcome

The next step is to work out the expected value of each decision. This is basically the

weighted average of the outcomes taking into account the probability of each one.

Expected Value =

(The probability X the outcome of each) + answers together = Expected Value

To calculate the expected vale we multiply the probability of each outcome with the

financial consequences of the outcome and then add them all up. This shows how much the

firm would earn on average if the decision was taken repeatedly. A manager would always

choose the one that provided the highest value. The expected values are written in the

outcome circles and the options which are not chosen are shown using a doubled crossed

line.

Using a decision tree can be very useful for managers because it:

Makes them think about the different options they have and consider the possible

consequences of each one

Forces them to quantify the impact of each decision

Helps them to logically compare the options open to them

However decision trees do have various limitations and drawbacks:

Decision trees use estimates of the probability of different outcomes and the

financial consequences of each outcome. The value of decision tree analysis

depends heavily on how accurate these estimates are.

Decision trees only include financial and quantifiable data; they do not include

qualitative issues such as the workforce's reaction to different options or the

impact on the firs image.

Developing Decision Tree Analysis

In reality there may be several different outcomes following any decision; it is also

possible that a particular decision leads to losses if things go wrong. Initial costs of

undertaking a particular course will also need to be included; this is taken of the Expected

Value.

The Role of Risk

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