Decision Trees

• Decision tree is a mathematical model used to help managers make decisions in uncertain situations
• Decision tree involves making assumptions, estimating probabilities, and calculating likely outcomes to determine the best decision
• Decision tree uses estimates and probabilities, so it's important to question the accuracy and optimism of these estimates
• Steps to building a decision tree:

  • Identify options and choices
  • Add possible outcomes for each option
  • Include costs of each option
  • Determine probabilities and financial results for each outcome
• Probabilities in decision trees range between 0 (no chance) and 1 (certainty)
• Expected value of an outcome is calculated by multiplying the financial result by the probability
• Net gain is calculated by subtracting the cost of the option from the total expected value of outcomes
• Decision trees are sensitive to assumptions and small changes in probabilities or financial results can lead to different outcomes
• Decision trees are one method among many that management can use for decision-making