Multi-stage Decision

Making
Decision Tree

Decision Trees
The Payoff Table approach is useful
for a non-sequential or single stage.
Many real-world decision problems
consists of a sequence of dependent
decisions.
Decision Trees are useful in analyzing
multi-stage decision processes.
2

Characteristics of a decision
tree
A Decision Tree is a chronological representation
of the decision process.
The tree is composed of nodes and branches.

Decision
n1
o
i
s
node Deci t 1

Cos
Dec
isio
C os n 2
t2

Chance (S 1)
P
node

P(S2)

P(S
)
3

A branch emanating from a

decision node corresponds to a
decision alternative. It includes a
cost or benefit value.

)
P(S 1 A branch emanating from a state of
P(S2) nature (chance) node corresponds to a
P(S particular state of nature, and includes
3)
the probability of this state of nature.
3

BILL GALLEN DEVELOPMENT COMPANY

BGD plans to do a commercial development on
a property.
Relevant data

Asking price for the property is 300,000 dollars.

Construction cost is 500,000 dollars.
Selling price is approximated at 950,000 dollars.
Variance application costs 30,000 dollars in fees and
expenses
There is only 40% chance that the variance will be
approved.
If BGD purchases the property and the variance is denied,
the property can be sold for a net return of 260,000 dollars.
A three month option on the property costs 20,000 dollars,
which will allow BGD to apply for the variance.
4

BILL GALLEN DEVELOPMENT

COMPANY
A consultant can be hired for 5000 dollars.
The consultant will provide an opinion about
the approval of the application
P (Consultant predicts approval | approval granted)
= 0.70
P (Consultant predicts denial | approval denied) =
0.80

BGD wishes to determine the optimal

strategy
Hire/ not hire the consultant now,
Other decisions that follow sequentially.
5

BILL GALLEN - Solution

Construction of the Decision Tree
Initially the company faces a decision about

hiring the consultant.

After this decision is made more decisions
follow regarding
Application for the variance.
Purchasing the option.
Purchasing the property.
6

BILL GALLEN - The Decision Tree

n
lu ta

ns
o
c
ih re t = 0
ot
os
n
C
o

Hir
ec
on
su
Co
lt
st
= - ant
50
00

ing
h
t
o
Do n 0
Buy land
-300,000
Pu
rc h
ase
-20
op
,00
tion
0

Le
to t us
no co
t h ns
ire ide
a c r th
on e d
su ec
lta is
nt i on

0
3

Apply for variance

-30,000

Apply for variance

-30,000

BILL GALLEN - The Decision Tree

Buy land and
apply for variance
ved
o
r
App .4
0
Den
ied
0.6

12

ove
r
p
Ap
0.4
Den
ied

Build
-500,000

-300000 30000 500000 + 950000 = 120,000

Sell
950,000

Buy land

-300000 30000 + 260000 = -70,000

Sell
260,000
Build
Sell

-300,000

-500,000

950,000

100,000

0.6

Purchase option and

apply for variance

-50,000
8

BILL GALLEN - The Decision Tree

Buy land and

apply for variance

Buy land
-300,000

Build
-500,000

-300000 30000 500000 + 950000 = 120,000

Sell
950,000

Buy land

-300000 30000 + 260000 = -70,000

Sell
260,000
Build
Sell

-300,000

-500,000

Apply for variance

-30,000

950,000

100,000

Apply 12
for variance
-30,000
Purchase option and
apply for variance

-50,000
61

This is where we are at this stage

60

Let us consider the decision to hire a consultant

9

ant
t
l
u
s
con
e
r
i
h
ot
Do n
0
Hir
e

Do

ict al
d
e v
Pr pro
Ap

0.4

co
n
-50 sulta
nt
00

Done

-5000

g
thin
o
N

Buy land
-300,000
Pu r
ch a
se o
ptio
-20,
n
000

Apply for variance

-30,000
Apply for variance
-30,000

t
dic
Pre nial
De

0.6

Let us consider the

decision to hire a
consultant

BILL GALLEN
The Decision Tree

othin
N
o
D

Buy land
-300,000
Purc
hase
optio
-20,0
n
00

-5000
Apply for variance
-30,000

Apply for variance

-30,000
10

BILL GALLEN - The Decision Tree

Build
-500,000

ved
o
r
App
?
Den
ied

Sell
260,000

?
Co
ns
ult
an

tp

Sell
950,000

r ed

icts

an

ap
p ro

115,000

-75,000

va
l
11

BILL GALLEN - The Decision Tree

ved
o
r
App
?
Den
ied

Build
-500,000

Sell
950,000

Sell
260,000

115,000

-75,000

The consultant serves as a source for additional information

about denial or approval of the variance.

12

BILL GALLEN - The Decision Tree

ved
o
r
App
?
Den
ied

Build
-500,000

Sell
950,000

Sell
260,000

115,000

-75,000

Therefore, at this point we need to calculate the

posterior probabilities for the approval and denial
of the variance application
13

BILL GALLEN - The Decision Tree

22

ved
o
r
App
?
Den .7
ied

?
.3

23

26

Build
-500,000

24

Sell
950,000

Sell
260,000

115,000

25

-75,000

27

Posterior Probability of (approval | consultant predicts approval) = 0.70

Posterior Probability of (denial | consultant predicts approval) = 0.30

The rest of the Decision Tree is built in a similar manner.

14

The Decision Tree

Determining the Optimal Strategy
Work backward from the end of each branch.
At a state of nature node, calculate the
expected value of the node.
At a decision node, the branch that has the
highest ending node value represents the
optimal decision.

15

BILL GALLEN - The Decision Tree

Determining the Optimal Strategy
00
5
0
)=8 00
7
.
)(0 805
0
0
,0 500
5
1
(1 0800
805
ved
o
r
p
58,000 Ap
0.70
?
D
22
enie
-22
d
50
0
(-7 -225 0.30
5,0 00 ?
00
)(0 -22
.3) 500
=22
50
0

115,000

23
-75,000

26

115,000
Build
-500,000
-75,000

115,000

115,000

24

Sell
950,000

-75,000

-75,000

Sell
260,000

With 58,000 as the chance node value,

we continue backward to evaluate
the previous nodes.

115,000

115,000
115,000

25
-75,000

-75,000
-75,000

27

16

BILL GALLEN - The Decision Tree

Determining the Optimal Strategy
$115,000
Build,
Sell

$10,000

Hi
re $20,000

App
r

ove
d

t
o
$20,000 Do n
e
r
i
h

$58,000
icts
d
e
r
P

Buy land; Apply

for variance

val
o
r
p
ap

.4

icts
den
ial

.6

ied
Den

Pre
d

.7

$-5,000

.3
Sell
land

Do nothing

$-75,000
17

BILL GALLEN - The Decision Tree

Excel add-in: Tree Plan

18

BILL GALLEN - The Decision Tree

Excel add-in: Tree Plan

19