Decision Tree Analysis
Basically decision tree analysis is a graphic display of the relationship between a present decision and future events, future decision and their consequences.
This approach assumes that there are only two types of situation that a finance manager has to face. The first situation is where the manager has control or power to determine what happens next. This is known as “Decision”.
The second situation is where finance manager has no control over what happens next. This is known as “Event”. Since the outcome of the events is not known, a probability distribution needs to be assigned to the various outcomes or consequences. It should, however, be noted when a finance manager faced with a decision situation, he is assumed to act rationally.
Steps involved in Decision Tree analysis:
Step 1- Define Investment: Decision three analysis can be applied to a variety of business decision-making scenarios. Normally it includes following types of decisions.
• Whether or not to launch a new product, if so, whether this launch should be local, national, or international.
• Whether extra production requirement should be met by extending the factory or by out sourcing it to an external supplier.
• Whether to dig for oil or not if so, upto what height and continue to dig even after finding no oil upto a certain depth.
Step 2- Identification of Decision Alternatives: It is very essential to clearly identity decision alternatives. For example if a company is planning to introduce a new product, it may be local launch, national launch or international launch.
Step 3- Drawing a Decision Tree: After identifying decision alternatives, at the relevant data such as the projected cash flows, probability distribution expected present value etc. should be put in diagrammatic form called decision tree.
While drawing a decision tree, it should be noted that NPVs etc. should be placed on the branches of decision tree, coming out of the decisions identified.
Step 4- Evaluating the Alternatives: After drawing out the decision the next step is the evaluation of alternatives.
Decision Tree Analysis
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