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Decision Trees Analysis

This document presents 5 case studies involving decision trees to analyze various business decisions: 1) Case I examines whether a company should set up a large or small refrigerator plant based on demand projections. 2) Case II analyzes whether a company should first do a pilot test of a new product or immediately start commercial production. 3) Case III considers the optimal drilling depth for a well given success probabilities at different depths. 4) Case IV evaluates the best time for an art dealer to purchase a painting to maximize expected profit. 5) Case V uses a decision tree to determine if an oil company should bid on an offshore contract based on the probabilities and returns of different drilling operations.

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Siddhesh Asatkar
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114 views3 pages

Decision Trees Analysis

This document presents 5 case studies involving decision trees to analyze various business decisions: 1) Case I examines whether a company should set up a large or small refrigerator plant based on demand projections. 2) Case II analyzes whether a company should first do a pilot test of a new product or immediately start commercial production. 3) Case III considers the optimal drilling depth for a well given success probabilities at different depths. 4) Case IV evaluates the best time for an art dealer to purchase a painting to maximize expected profit. 5) Case V uses a decision tree to determine if an oil company should bid on an offshore contract based on the probabilities and returns of different drilling operations.

Uploaded by

Siddhesh Asatkar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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Decision Trees Analysis

Case I Alfa industries have to decide whether to set up a large plant or a small plant for
its new range of refrigerators. A large plant will cost the company Rs 250 lakhs while a
small plant will cost Rs 120 lakhs. An extensive market survey and a cost profit volume
analysis carried out by the company reveal the following estimates for sales over the next
10 years:
High demand Probability = 0.5
Moderate demand Probability = 0.3
Low demand Probability = 0.2
(a) A large plant with high demand will yield an annual profit of Rs 100 lakhs
(b) A large plant with moderate demand will yield an annual profit of Rs 60 lakhs
(c) A large plant with low demand will yield loss of Rs 20 lakhs annually because
of production inefficiencies
(d) A small plant with high demand will yield an annual profit of Rs 25 lakhs, taking
into account the cost of lost sales due to inability to meet demand.
(e) A small plant with moderate demand will yield an annual profit of Rs 35 lakhs, as
the losses due to lost sales will be lower.
(f) A small plant with low demand will yield an annual profit of Rs 45 lakhs, as the
plant capacity and demand will match.
Case II A Company is introducing a new product. It has the option of setting up a
commercial plant now or setting up a pilot plant at present and setting up a commercial
plant later depending on the performance of the product. It has been estimated that the
present cost of setting up the pilot plant will be Rs 2 lakhs and the setting of commercial
plant will be Rs 21 lakhs. However, when the commercial plant is set up three months
later, after observing the performance of the product it will cost Rs 25 lakhs.
It has also been estimated that the probability of the product giving a high yield during
the pilot stage is 0.9 and that of giving a low yield is 0.1. If the product is introduced
commercially without going through a pilot stage, it is expected that it will give a high
yield of profits with a probability of 0.7. If the pilot plant does show a high yield then the
probability that the commercial plant will also give a high yield is 0.85; but if the pilot
plant gives a low yield, the probability that the commercial plant will give a high yield is
0.1. The estimated profits from high yield at the commercial stage are Rs 122.5 lakhs and
if the yield is low, the company will suffer a loss of Rs 15.25 lakhs.
Case III A Finance manager is considering drilling a well. In the past, only 70% of wells
drilled were successful at 20 meters depth in that area. Moreover, on finding no water at
20 meters, some persons in that area drilled it further up to 25 meters, but only 20%
struck water at that level. The prevailing cost of drilling is Rs 500 per meter. The Finance
manager estimated that in case he does not get water in his own well, he will have to pay
Rs 15,000 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 up to 20 meters, and
(iii) If no water is found, drill further up to 25 meters.
Draw an appropriate decision tree and determine the Finance Manager’s optimal strategy.
Case IV An art dealer’s client is willing to buy the painting Sun Plant at $50,000. The
dealer can buy painting today for $40,000 or can wait a day and buy the painting
tomorrow (it has not been sold) for $30,000. The dealer may also wait another day and
buy the painting (if it is still available) for $26,000. At the end of the third day, the
painting will no longer be available for sale. Each day, there is a .60 probability that the
painting will be sold. What strategy maximizes the dealer’s expected profit?
Case V The Oil India is considering whether to go for an offshore contract to be awarded
in Bombay High. If they bid, the value would be Rs 600 million with 65% chance of
gaining the contract. The corporation 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 is as follows:
Outcome New Drilling Operation Existing Operation
Probability Expected Probability Expected
Revenue (Rs Revenue (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 Rs 600 million to
modernize their operations. This would result in a return of either 5% or 8% on the sum
invested with probabilities 0.45 and 0.55, respectively.
(a) Construct a decision tree for the problem showing clearly the courses of action.
(b) By applying an appropriate decision criterion recommend whether or not the
corporation should bid the contract.

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