Decision Trees

1. Growfast 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

The returns for each investment opportunity and each state of the economy are as
follows :

State of the economy

Alternative Fair (Rs.) Good (Rs.) Great (Rs.)
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. Which alternative investment proposal would you recommend if the
expected monetary value criterion is to be employed ?

Ans. : Invest in Y; Value Rs. 4,900

2. The investment staff of TNC Bank is considering four investment proposals for a
client : Shares, Bonds, Real estate and Savings Certificates. The investments will be
held for one year. The past data regarding the four proposals are given below :

SHARES There is a 25 % chance that shares will decline by 10 %, a

30 % chance that they will remain stable and a 45 % chance
that they will increase in value by 15 %. Also the shares
under consideration do not pay any dividends.

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 20 % in value, a 40 %
chance of increasing 10 % in value, a 10 % chance of
remaining stable and a 5 % chance of losing 5 % of its
value.
SAVINGS These certificates yield 8.5 % with certainity.
CERTIFICATES

Use a Decision tree structure for the alternatives available to the investment staff,
and using the expected value criterion, choose the alternative with the highest
expected value.
Ans. : Invest in Real Estate, Rs. 114.75

3. A finance manager is considering drilling a well. In the past only 70 % of wells

drilled were successful at 20 metres depth in that area, moreover on finding no water
at 20 metres some persons in that area drilled it further upto 25 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 :
a) do not drill any well
b) drill upto 20 metres and
c) if no water is found at 20 metres, drill further upto 25 metres.
Draw an appropriate decision tree and determine the finance manager’s optimal
strategy.
Ans. : Drill upto 20M, if there is no water
Drill upto 25M; Value Rs. 14,350

4. A company is contemplating whether to produce a new product. If it decides to

produce the product it must either install a new division which needs a cash outlay of
Rs.4,00,000/- or work overtime with OT expenses of Rs.1,50,000/-. If the company
decides to install a new division it needs the approval of the Government and the
company feels that there is a 70 % chance of getting the approval. A market survey
has revealed the following facts regarding the magnitude of sales for the new
products
Magnitude of Sales Probability Resulting Profits in Lakhs
High 0.45 15
Medium 0.30 7
Low 0.20 3
Nil 0.05 -5 (Loss)
However by resorting to overtime the company will not be in a position to meet
the high magnitude of sales, it will be able to satisfy upto the level of medium
magnitude only, even if high magnitude of sales results. Solve the problem to
suggest which option should be selected.
Ans. : Produce New Product by resortingto Over Time; Rs. 4.1 lacs

5. Mr. X is trying to decide whether to travel to Sri Lanka from Delhi to negotiate sale
of a shipment of Chinese novelties. He holds the novelties stock and is fairly
confident but by no means sure that if he makes the trip he will sell the novelties at a
price that will give him a profit of Rs.30,000/-. He puts the probability of obtaining
the order at 0.6. If he does not make the trip he will certainly not get the order. If the
 novelties are not sold in Sri Lanka there is an Indian customer who will certainly buy
them at a price that leaves him a profit of Rs.15,000/- and this offer will be open
atleast till Mr.X returns from Sri Lanka. Mr.X estimates the expenses of the trip to Sri
Lanka at Rs.2500/-, he is however concerned that his absence even only for 3 days
will lead to production inefficiencies in the factory. These could cause him to miss
the deadline on another contract, with the consequence that a late penalty of
Rs.10,000/- will be invoked. Mr.X assesses the probability of missing the deadline
under these circumstances at 0.40 further he believes that in his absence there would
be a lower standard of house keeping in the factory. If the raw material and labour
costs on the other contract will rise by Rs.2000 above the budgeted figure.

Draw an appropriate decision tree for Mr.X’s problem and using EMV as the
appropriate criterion for the decision find the appropriate initial decision.
Ans. : X should proceed Srilanka; Value Rs. 15,500
6. M/s B and Company is currently working with a process which after paying for
materials, labour etc., brings a profit of Rs.10,000/-. The following alternatives are
made available to the company :

a) The company can conduct research (R1) which is expected to cost Rs.10,000/-
and having 90% probability of success, the company gets a gross income of
Rs.25,000/-.

b) The company can conduct research (R2) expected to cost Rs.5,000/- and having
a probability of 60% success. If successful, the gross income will be Rs.25,000/-.

c). The company can pay Rs.6,000/- as royalty of a new process which will bring
a gross income of Rs.20,000/-.

d) The company continues the current process.

Because of limited resources, it is assumed that only 1 of the 2 types of research

can be carried out at a time.
Ans. :R2 is followed by Royalty; Value Rs.15,600

7. A businessman has two independent investments A and B available to him, but he

lacks the capital to undertake both of them simultaneously, he can choose to take A
first and then stop or if A is successful then take B or vice-versa. The probability of
success of A is 0.70 while for B it is 0.40. Both investments require an initial capital
outlay of Rs.2,000/- and both return nothing if the venture is unsuccessful. Successful
completion of A will return Rs.3000/- (over cost) and successful completion of B will
return Rs.5000/- (over cost). Draw the decision tree and determine the best strategy.
Ans. :Accept A, if it is successful Accept B; Value Rs. 2,060

8. Oil India Corporation is considering whether to go for an offshore oil drilling contract
to be awarded in Bombay. If they bid value would be Rs.600 million with a 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 New Drilling Operation Existing Operation expected

Probability expected Revenue probability Revenue (in Rs.
(in Rs. Million) Million)
Success 0.75 800 0.85 700
Failure 0.25 200 0.15 350
If the corporation does not bid or lose the contract, they can use the 600 million to
modernise their operations, this would result in a return of either 5% or 8% on the
sum invested with probabilities of 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 an appropriate decision criteria recommend whether or not Oil
India Corporation should bid for the contract.

Ans. :Bid the contract and go for New Drilling operation ; Vlaue Rs. 46.46 Million

9. The Indian Yacht Company has developed a new Cabin Cruiser, which they have
earmarked for the medium to large boat market. The market analysis has a 30%
probability of Annual sales being 5000 boats, 40% probability of 4000, and 30%
probability of 3000 boats. The company can go into limited production where
variable costs are Rs.10,000/- per boat and fixed costs are Rs.8,00,000/- annually.
Alternatively they can go into full scale production where variable costs are
Rs.9,000/- per boat and fixed costs are Rs.50 Lakhs annually. If the new boat is to be
sold for Rs.11,000/- should the company go into limited of full scale production when
their objective is to maximise the expected profits.

Ans. : Limited Production ; Rs. 32 Lacs

10. An oil company has recently acquired rights in a certain are to conduct surveys and
test drilling to lead to lifting oil. The area is considered to have good potential for
finding oil. At the outset the company has a choice to conduct further geological tests
or to carry out a drilling programme immediately. On the known conditions, the
company estimates that there is a 70 : 30 chance of further tests showing a “Success”.
Whether the tests show the possibility of ultimate success or not or even if no tests
are undertaken at all, the company could still pursue its drilling programme or
alternatively consider selling its rights to drill the area. Thereafter, however, if it
carries out the drilling programme, the likelihood of final success or failure is
considered dependent on its foregoing stages. Thus if successful tests have been
carried out the expectation of success in drilling is given as 80 : 20. If the tests
indicate “Failure” then the expectation of success in drilling is given as 20 : 80. If no
tests have been carried out at all, the expectation of success in drilling is given as
55 : 45. Costs and Revenues have been estimated for all possible outcomes and the
net present value of each is given below :
 Outcomes Net Present Value
(Rs. Millions)
Success
With Prior tests 100
Without Prior tests 120
Failure
With Prior test s (-) 50
Without Prior tests (-) 40
Sale of exploitation rights
Prior tests show success 65
Prior tests show failure
15
Without prior tests 45

Draw a decision tree diagram to represent the above information. Evaluate the
tree in order to advise the management of the company on its best course of
action.
Ans. : Test, if it is +ve Drill,
If it is -ve Sell; Value Rs. 53.50

11. A client asks an estate agent to sell 3 properties A, B, & C for him and agrees to pay
him a 5 % commission on each sale. He specifies certain conditions. The estate agent
must sell A first and this he must do within 60 days. If and when A is sold the agent
receives his 5 % commission on that sale. He can either back out at this stage or
nominate and try to sell one of the two remaining properties within 60 days. If he
does not succeed in selling the nominated property in that period, he is not given the
opportunity to sell the other. If he does sell it in the period, he is given the
opportunity to sell the third property on the same conditions. The following table
summarises the prices, selling costs (incurred whenever a sale is attempted) and the
agent’s estimated probability of making a sale.

Data for Property Sales

Property Price Rs. Selling Costs Rs. Probability
A 12000 400 0.7
B 25000 225 0.6
C 50000 450 0.5

(i) draw an appropriate decision tree for the estate agent.

(ii) what is the estate agent’s best strategy under EMV approach ?

Ans. : Accept offer to try to sell A-if able to sell A,

Then try to sell C-if able to sell C, try to sell B.