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Business 70 PDF

This document discusses using decision trees to analyze options with uncertain outcomes. It provides an example decision tree comparing holding a fund-raising auction indoors versus outdoors. Calculating the expected value at each chance node by multiplying probabilities and payoffs, holding the event outdoors has the highest expected value of $4,600 after subtracting costs. Decision trees are useful but rely on accurate data, and probabilities and outcomes may change over time.

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Lissa Montiel
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1K views1 page

Business 70 PDF

This document discusses using decision trees to analyze options with uncertain outcomes. It provides an example decision tree comparing holding a fund-raising auction indoors versus outdoors. Calculating the expected value at each chance node by multiplying probabilities and payoffs, holding the event outdoors has the highest expected value of $4,600 after subtracting costs. Decision trees are useful but rely on accurate data, and probabilities and outcomes may change over time.

Uploaded by

Lissa Montiel
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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06 Organisational planning tools

0.6 Fine
$5000

Indoors
($2000)
0.4 Poor
$7000

0.6 Fine
$10 000

Outdoors
($3000)
0.4 Poor
$4000

Figure 6.3 Decision tree for the fund-raising auction

Using the tree diagram in Figure 6.3, which option would Therefore, the events manager would be advised to
give the highest expected value – holding the event hold the event outdoors as, on average, this will give the
indoors or outdoors? The answer is gained by calculating highest expected value. The other option is ‘blocked off’
the expected value at each of the chance nodes. This is with a double line in the figure to indicate that this deci-
done by multiplying the probability by the economic sion will not be taken.
return of both outcomes and adding the results. The
cost of each option is then subtracted from this expected Decision trees – an evaluation
value to fi nd the net return. The primary limitation concerns the accuracy of the data
This is done by working through the tree from right to used. Estimated economic returns may be quite accurate
left, as follows (see Figure 6.4): when they concern projects where experience has been
gained from similar decisions. In other cases, they may
● The expected value at node 1 is $5800. be based on forecasts of market demand or ‘guestimates’
● The expected value at node 2 is $7600. of the most likely fi nancial outcome. In these cases, the
● Subtract the cost of holding the event either indoors or scope for inaccuracy of the data makes the results of
outdoors. decision-tree analysis a useful guide, but no more. In
● Indoors = $5800 – $2000 = $3800 addition, the probabilities of events occurring may be
● Outdoors = $7600 – $3000 = $4600 based on past data, but circumstances may change. What

ACTIVITY 6.1 Demand Petrol forecourt Car showroom


Read the case study below and then answer the questions
High $500 000 $800 000
that follow.
Low $400 000 $200 000

Expansion decision The economic returns from the two options


The owner of a service station is planning to expand the
business. The two options are to build a forecourt to sell 15 marks, 28 minutes
petrol or to construct a showroom to sell cars. The esti-
mated building costs are: petrol forecourt – $100 000; 1 Show these options on a decision tree, adding the
car showroom – $150 000. The forecast economic conse- pay-offs and probabilities. [6]
quences or pay-offs during the expected lives of these
2 Calculate the expected value of both investments and
investments will depend on the level of demand in the
recommend which option should be taken. [6]
economy, as shown in the table below. The probability
of demand being low during the life span of these invest- 3 State three other factors that you consider might
ments is 0.2 and the probability of high demand is 0.8. influence the business owner’s final decision. [3]

62

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