3.5 Analysis

You analyze a decision tree after all the probabilities, payoff values, and expected values are identified. The decision branch with the highest EV at the root node is the best decision. The results may come as a surprise, so use the decision tree to trace how the results are generated.

You can also see how changing various payoffs or probabilities can affect the results since a decision tree is a system of multiple inputs and outputs. The analyst can change input values to understand how changes affect the system. Use a spreadsheet to alter payoff or probability values to monitor how the analysis changes.

icon_example Example
The EV at the root node shows that the decision to wait for the marketing report is the best decision. This result may come as a surprise.
Before the decision tree in Figure 3.4 is analyzed you may be tempted to assume that the decision to develop the project immediately is the better choice. After all, the project will only cost $1,000,000 instead of a rush cost of $1,500,000. Furthermore, there are fewer complications to consider, like waiting to determine the potential for international distribution.

The EV for the decision alternative to wait for the report is complicated by two major chance factors. One factor is that the company knows that waiting makes finding an international distributor more difficult than if the project begins immediately. The company has determined that the likelihood of finding an international distributor is less certain (by 50%) if they wait for the report.

The other chance factor is the information in the marketing report. The company estimates that the marketing report has a 50% chance of delivering favorable data that will help project development. Two or more chance nodes directly connected in this way indicate a dependent uncertainty, a condition that can readily be evaluated through decision tree analysis.

Another complication is that rushing development raises development costs by a third, to (-$1,500,000), and this alone reduces the payoff for the international and domestic marketing by $500,000.

The decision tree method requires probabilities for all chance outcomes. In this example, the successive chance outcomes of waiting for report results and then securing an international distributor reduce the EV along the branch path.

But a similar analysis of the competing decision alternative reveals important information. Without the benefit of the marketing report, the chances of “getting it right” for the international market are fairly low, at 20%. This factor significantly weakens the value of that branch. This alternative is also risky; there is a 30% chance that the company will lose all investment costs. The absence of reliable market information means that the project may not meet criteria for success in any market.

Figure 3.5

3_5


The analyst can sum up the decision tree analysis with the following major presentation points and with the decision tree in figure 3.5.
  • The international market potential is $3,000,000 in revenue, while the domestic market potential is only $500,000.
  • Immediate project development costs only $1,000,000.
  • Waiting to develop the project results in rush costs, pushing the total to $1,500,000.
  • Marketing information plays the most important role in the potential success of this project. In the absence of valid marketing data, the chance for success in the international market is poor (20%) and the chance for complete failure is significant (30%). These risk factors significantly reduce the potential for product success.
  • Waiting for the marketing report can complicate project development. There is a 50% chance that the report will be favorable enough to go forward with development. Waiting also reduces the chance (by 50%) for recruiting a distributor in time to capture the international market. However, these risk factors of waiting do not affect the chance of success as much as the absence of marketing data.
  • Therefore the best decision, given the known assumptions, uncertainties, and information, is to wait for the results of the marketing report before deciding to develop the project.


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