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Decision Trees in Financial Analysis

Decision Trees are a valuable tool in financial analysis, helping to clarify capital investment opportunities and evaluate business decisions by mapping out alternatives and outcomes. They consist of nodes and branches, where branches represent decisions and nodes represent chance events, allowing for a systematic analysis of relevant factors. While not suitable for every minor decision, Decision Trees facilitate a rigorous decision-making process by illustrating the structure of investment decisions and calculating expected cash flows based on probabilities.

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90 views3 pages

Decision Trees in Financial Analysis

Decision Trees are a valuable tool in financial analysis, helping to clarify capital investment opportunities and evaluate business decisions by mapping out alternatives and outcomes. They consist of nodes and branches, where branches represent decisions and nodes represent chance events, allowing for a systematic analysis of relevant factors. While not suitable for every minor decision, Decision Trees facilitate a rigorous decision-making process by illustrating the structure of investment decisions and calculating expected cash flows based on probabilities.

Uploaded by

ghoshpradipto13
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 PDF, TXT or read online on Scribd
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Decision Trees in Financial Analysis

Introduction to Decision Trees

We use Decision Trees to clarify the expected value of capital investment


opportunities. Decision Trees can also be helpful in business operations,
where companies continuously struggle with big decisions on product
development, operations management, human resources, and others.
With Decision Tree analysis, we can better evaluate the alternative
options. However, we should not use the technique for every minor
decision the business faces. Decision Trees only give a general
framework to determine solutions and manage them.

This analysis method lets us explore the ranging elements influencing a


decision. Trying to determine all the critical variables leads us to create
very complex decision trees. However, this technique is still an essential
tool in the decision-making process and investment analysis.

We can also present Decision Trees as pay-off tables, showing all the
events and choices we can take.

Decision Tree Analysis


Decision Trees are made up of two elements: nodes and branches.

Each branch represents an alternative course of action or a decision. At


the end of each branch, there’s a node representing a chance event –
whether or not some event will occur. Branches to the right of nodes are
the alternative outcomes of a chance event. For each complete course of
action through the decision tree, there is a pay-off, shown right of the last
branch. It is a common practice to mark decision forks with squares and
chance forks with circles when illustrating a Decision Tree.

We base the outcomes for different sequences of decisions and events


on the current information available to us. We don’t try to identify all
decisions and events when building a Decision Tree. Instead, we focus
only on those that are relevant and important to our analysis and the
outcomes we want to compare.

Usually, only the first decision point has to be made right away, as the
following decision points (if any) are further in time. Executives take into
account the costs for each option and the probabilities for the possible
outcomes when they evaluate potential actions to take.

Evaluate Investment Opportunities With Decision Trees

Keep in mind that Decision Trees don’t show information that was not
already known by the management. Decision Trees have great value in
laying out what management knows in a way that enables systematic
analysis and leads to a more robust and rigorous decision-making
process. The technique is excellent for illustrating the structure of
investment decisions, and it can be crucial in the evaluation of investment
opportunities.

Decision Trees in financial analysis are a Net Present Value (NPV)


calculation that incorporates different future scenarios based on how likely
they are to occur. The cash flows for a given decision are the sum of cash
flows for all alternative options, weighted based on their assigned
probability

To prepare a Decision Tree analysis, we take the following approach:

1. Identify the points of decision and the alternative options available


at each of them;
2. Identify aspects of uncertainty and type or range of alternative
outcomes;
3. Estimate the values for the analysis:
o Probabilities of events and results from actions;
o Costs of and possible gains from various events and activities;
4. Analyze alternative amounts and choose a course (calculate the
present value for each state).
Decision Trees don’t provide a ready answer. They instead help
management determine which alternative at a particular choice point will
give the maximum return, based on the available information.

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