Decision Tree Analysis

Q.1. Crown Auto is trying to decide about the size of the plant to be built in Gujarat. Three alternatives of
annual capacity are under consideration:
a. 10,000 units
b. 20,000 units and
c. 30,000 units.
Demand for the product is not known with certainty but the management has estimated the
probabilities for 5 different levels of demand. The profit for each size of plant at different levels of
demand is as follows:

Level of demand Probability Profit (Rs. in lakhs)

Built Plant Capacity
10,000 units 20,000 units 30,000 units

Very High 0.15 -4 -6 -8

Light 0.30 1 0 -2
Moderate 0.25 1 7 5
Low 0.20 1 7 11
Very Low 0.10 1 7 11

What plant capacity would you suggest to the management? Also draw the decision tree.

Q.2. A Finance Manager is considering drilling a well. In the past, only 70% of the wells drilled were
successful at 20 metres depth in that area. Moreover on finding no water at 20 metres , some people in
that area drilled it further upto 25 metres(i.e. by another 5 metres beyond the initial 20 metres) but only
20% struck water at that level. The prevailing cost of drilling is Rs. 500 per metre. The Finance
Manager estimated that in case he does not get water in his own well, he will have to pay Rs. 15000 to
buy water from outside for the same period of getting water from the well. The following decisions are
considered:
i) Do not drill any well;
ii) Drill upto 20 metres; and
iii) If no water is found at 20 metres, drill further upto 25 metres.
Draw an appropriate decision tree and determine the Finance Managers optimal strategy.

Q.3. A manger has a choice between (i) A risky contract promising Rs. 7 lakhs with probability 0.6 and Rs. 4
lakhs with probability 0.4, and (ii) A diversified portfolio consisting of two contracts with independent
outcomes each promising Rs. 3.5 lakhs with probability 0.6 and Rs. 2 lakhs with probability 0.4
Construct a decision tree for arriving at a decision using EMV criteria .

Q.4. A firm is planning to develop and market a new drug. The cost of extensive research to develop the drug
has been estimated at Rs. 1,00,000. the manager of the research programme has found that there is 60%
chance that the drug will be developed successfully. The market potential has been assessed as follows:

Market conditions Probability PV of profits (Rs.)

Large market potential 0.1 50,000

Moderate market potential 0.6 25,000
Low market potential 0.3 10,000
 The present value figures do not include the cost of research. While the firm is considering this
proposal, a second proposal, almost similar, comes up for consideration. The second one also requires
investment of Rs. 1,00,000, but the present value of all profits is Rs. 12,000. of course the return on
investment in the second proposal is certain.
a. Draw a decision tree indicating all the events and choices of the firm.
b. What decision the firm should take regarding the investment of Rs. 1,00,000?

Q.5. Grow Fast Company is evaluating four alternative single period investment opportunities whose returns
are based on the state of the economy. The possible states of the economy and the associated probability
distribution is as follows:

State Fair Good Great

Probability 0.2 0.5 0.3

Alternative State of economy (figures in Rs.)

Fair Good Great
W 1000 3000 6000
X 500 4500 6800
Y 0 5000 8000
Z 4000 6000 8500
Using the decision tree approach, determine the expected return for each alternative. What alternative
investment proposal would you recommend if the expected monetary value criterion is to be employed?

Q.6. The investment staff of TNC Bank is considering four investment proposals for a client: shares, bonds,
real estates and savings certificate. These investments will be held for one year. The past data regarding
the four proposals are given below:

Shares : There is 25% chance that the shares will dcline by 10%, a 30% chance that they will remain
stable and 45% chance that they will increase in value by 15%. Also the shares under consideration do
not pay any premium.

Bonds : These bonds stand a 40% chance of increase in value by 5% and 60% chance of remaining
stable and they yield 12%.

Real Estate: This proposal has a 20% chance of increasing 30% in value, a 25% chance of increasing in
20% value, a 40% chance of increasing in 10% value, a 10% chance of remaining stable and a 5%
chance of losing 5 % of its value.

Savings Certificate: These certificates yield 81/2 % with certainty.

Use a decision tree to structure the alternatives available to the investment staff, and using the
expected value criterion, choose the alternative with the highest expected value.

Q.7. A large steel manufacturing company has three options with regard to production:
a. Produce commercially,
b. Build pilot plant, and
c. Stop producing steel.
 The management has estimated that the pilot plant, if built, has 0.8 chance of high yield and 0.2 chance
of low yield. If the pilot plant does show high yield, management assigns the probability of 0.75 that
the commercial plant will also have a high yield. If the pilot plant shows a low yield, there is 0.1
chance that the commercial plant will show a high yield. Finally the managements best assessment of
the yield on a commercial- size plant without building a pilot plant first has a 0.6 chance of high yield.
A plant will cost Rs. 3,00,000. the profits earned under high and low yield conditions are Rs.
1,20,00,000 and
Rs. 12,00,000 respectively. Find the optimum decision for the company.

Questions for self assessment

Q.8. The Oil India Corporation is considering whether to go for an offshore oil drilling contract to be
awarded in Bombay High. If they bid, Value would be Rs. 600 million with 65% chance of gaining the
contract. They may set up a new drilling operation or move already existing operation, which has
proved successful, to the new site. The probability of success and expected returns are as follows:
Outcome Probability New Drilling Operation Probability Existing Operation
Expected Revenue Expected Revenue
(Rs. million) (Rs. million)
Success 0.75 800 0.85 700
Failure 0.25 200 0.15 350

If the corporation do not bid or lose the contract, they can use the Rs. 600 million to modernize their
operation. This would result in a return of either 5% or 8% on the sum invested with probabilities 0.45 and
0.55 (Assume that all costs and revenue have been discounted to present value)
a. Construct a decision tree for the problem showing clearly the course of action.
b. By applying the EMV criterion recommend whether or not the Oli India Corporation should
bid the contract.

Q.9. Matrix Company is planning to launch a new product, which can be introduced initially in Western India
or in the entire country. If the product is introduced only in the Western India, the investment outlay will
be Rs. 12 million. After two years, Matrix can evaluate the project to determine whether it should cover
the entire country. For such expansion it will have to incur an additional investment of Rs. 10 million.
To introduce the product in the entire country right in the beginning would involve an outlay of Rs. 20
million. The product, in any case, wil have a life of 5 years after which the plant will have zero net
value.

If the product is introduced only in Western India, demand would be high or low with the probabilities
of 0.8 and 0.2 respectively and annual cash outflow of Rs. 4 million and Rs. 2.5 million respectively.

If the product is introduced in the entire country right in the beginning the emand would be high or low
with the probabilities of 0.6 and 0.4 respectively and annual cash inflows of Rs. 8 million and Rs. 5
million respectively.

Based on the observed demand in the Western India, if the product is introduced in the entire country the
following probabilities would exist for high and low demand on all India basis:
Western India Whole Country
High Demand Low Demand
High demand 0.90 0.1
Low demand 0.40 0.6
 The hurdle rate applicable to its project is 12%.
Set up a decision tree for the investment situation.
Advice Matrix Company on the investment policy it should follow. Support your advice with
approximate reasoning.

Q.10. The owner of Hackers Computer Store is considering what to do with his business over the next five
years. Sales growth over the past couple of years has been good, but sales could grow substantially if a
major electronic firm is built in his area as proposed. Hackers owner sees three options. The first is to
enlarge his cur-rent store, the second is to locate at a new site, and the third is to simply wait and do
nothing. The decision to expand or move will take little time, and, therefore, the store would not loose
revenue. If nothing were done the first year and strong growth occurred, then the decision to expand will
be reconsidered. Waiting longer than one year would allow competition to move in and would
makeexpansion no longer feasible.
The assumptions and conditions are as follows:
1. Strong growth as a result of the increased population of computer fanatics from the new
electronics firm has a 55 percent probability.
2. Strong growth with a new site would give annual returns of Rs. 1,95,000per year. Weak growth
with a new site would mean annual returns of Rs. 1,15,000.
3. Strong growth with an expansion would give annual returns of Rs. 1,90,000 per year. Weak
growth with an expansion would mean annual returns of Rs. 1,00,000.
4. At the existing store with no changes, there would be returns of Rs. 1,70,000 per year if there is
strong growth and Rs. 1,05,000 per year if the growth is weak.
5. Expansion at the current site would cost Rs. 87,000.
6. the move to the new site would cost Rs. 2,10,000.
7. If the growth is strong and the existing site is enlarged during the second year, the cost would
still be Rs. 87,000.
8. Operating costs for all options are equal.