Decision trees practice questions:

Rana El Matarawi runs a textiles company and is considering developing and launching a new
product range at an estimated cost of $25,000. She has decided to use a decision tree with a 70%
probability of the new product range being a commercial success. If so, this should lead to an
additional $50,000 in sales revenue. The probability of failure is 30% which would lead to additional
sales of only $5,000.
Answers
(a) Define the term decision tree. [2 marks]
A decision tree is a visual tool which can be used by managers to make the right or best decision
based on quantitative factors. It enables managers to analyse and make estimates about the
possible outcomes of different courses of action and work out the likelihood of these occurring based
on a quantitative understanding of risks.
Award [1 mark] for a limited response that shows some understanding. Award [2 marks] for a clear
and accurate definition, similar to the example above.
(b) Calculate the expected value of the new product for Rana El Matarawi. [2 marks]
• Expected outcome of success = 0.70 × $50,000 = $35,000
• Expected outcome of failure = 0.30 × $5,000 = $1,500
• Total expected outcome = $35,000 + $1,500 = $36,500
• Net expected value = $36,500 – $25,000 = $11,500
Award [1 mark] for the correct answer, and [1 mark] for showing appropriate working out.
(c) Explain two advantages of using decision trees as a decision-making tool for the
business. [4 marks]
Possible advantages include:
• They enable managers like Rana El Matarawi to assess the risks associated with certain
decisions.
• They provide a quick and visual interpretation of the likely outcomes of decisions that need to be
made.
• They set out decision-making problems in a clear and logical way.
• Decision trees encourage managers to consider the financial costs of investment decisions.
• They encourage managers to make decisions based on logic and rationality rather than
emotions.
• They help managers to realise some of the risks and opportunities that they might not have
considered.
For each advantage, award [1 mark] for a plausible answer and [1 mark] for the explanation.
 EXAM PRACTICE QUESTION 2 -
Refer to the decision tree diagram below and answer the following questions.

[2
(a) Outline one limitation of using decision trees to support management decision making. marks]

Calculate the values of the predicted outcome for Project Atlanta and Project Boston shown in the decision [4
(b) marks]
tree diagram below.

[2
(c) Calculate the values of the net predicted outcome for each project. marks]

[2
(d) From your answers above, suggest which option should be chosen. marks]

Answers
(a) Outline one limitation of using decision trees to support management decision
making. [2 marks]
Possible limitations could include an outline of any of the following:

 The probabilities are just estimates and are prone to error or bias.

 Decision trees are quantitative in nature so ignore qualitative dimensions of decision

making.

 Using decision trees does not actually reduce the degree of risks involved.

 Accept any other valid limitation that is clearly outlined.

Award [1 mark] for identifying a valid limitation of decision trees, and a further [1 mark] for an
appropriate outline of the reason.
 (b) Calculate the values of the predicted outcome for Project Atlanta and Project Boston
shown in the decision tree diagram below. [4 marks]

Project Atlanta High Moderate Low Total

Success 0.6 0.2 0.2 1

Outcome $10m $6m $2m

Predicted outcome $6m $1.2m $0.4m $7.6m

Project Boston High Moderate Low Total

Success 0.5 0.3 0.2 1

Outcome $12m $6m $4m

Predicted outcome $6m $1.8m $0.8m $8.6m

Marks as a 2 + 2
For each project, award [1 mark] for showing appropriate working work, and a further [1 mark] for
the correct predicted outcome figure, up to the maximum of [4 marks].

(c) Calculate the values of the net predicted outcome for each project. [2 marks]

 Net predicted outcome = Predicted outcome – Cost

 Project Atlanta = $7.6m – $6m = $1.6m

 Project Boston = $8.6m – $7m = $1.6m

Apply the OFR (own figure rule) as appropriate, i.e., error carried forward.
Award [1 mark] for showing appropriate working out and a further [1 mark] for the correct answers.
(d) From your answers above, suggest which option should be chosen. [2 marks]
The decision tree analysis shows that both projects are expected to yield the same financial return of
$1.6m. In theory, this means either projects are feasible on quantitative grounds. In reality, Project
Atlanta may be preferable given the cost of the project is $1m less, and given that there is a lower
chance (probability) of success for Project Boston.
Award [1 mark] for an answer that shows limited understanding of the demands of the question. The response lacks substance or application of the decision tree.

Award [2 marks] for an answer that shows good understanding of the demands of the question, with appropriate use of the figures calculated in the decision tree.
 Exam Practice Question 3 - Bala Art Studios (BAS)
Bala Art Studios (BAS) is considering expanding into one of three locations. The expected costs
and revenues are shown below. BASonly has enough resources to pursue one of these options.

Location Probability (%) Cost ($m) Revenue ($m)

Ahmedabad 95

High sales 60 220

Low sales 40 85

Bengaluru 85

High sales 50 200

Low sales 50 75

Chennai 100

High sales 65 190

Low sales 35 90

Construct a decision tree diagram for BAS, showing which location is best on financial grounds.
(a) Show all your working and include an appropriate key in your diagram.

(b) Comment on the findings shown in the decision tree.

(a) Construct a decision tree diagram for BAS, showing which location is best on financial
grounds. Show all your working and include an appropriate key in your diagram. [6 marks]

Award [1 to 2 marks] if there is some evidence of a general knowledge of decision trees, but it is not
accurately constructed. The calculations of each option are not all presented or are inaccurate.
Award [3 to 4 marks] if the main elements of the decision tree are constructed, but may not be
entirely accurate or the working may not be shown. For [4 marks], the calculations for each option
are largely correct and presented clearly.
Award [5 to 6 marks] if the decision tree is accurately constructed. The calculations of each option
are correct and well presented, with appropriate working out shown. For [6 marks], an appropriate
key is provided

(b) Comment on the findings shown in the decision tree. [2 marks]

The outcomes of the decision tree suggest shows that Ahmedabad is the best location to expand to,
based on financial measures. Despite the relatively high cost compared to Bengaluru, there is a
smaller chance of success should BAS choose to use expand there. Whilst Chennai has the highest
chance of success (65%), the higher investment cost ($100m) and lower absolute return ($190m),
mean that Ahmedabad is the best option, financially. Essentially, the lower cost investment ($95m vs
$100m) yields a higher probable return ($71m vs $55m).
Award [1 mark] for an answer that shows some understanding of the demands of the question, but
without clear application of the data in the decision tree.
Award [2 marks] for an answer that shows clear understanding of the demands of the question, with
relevant use of the data in the decision tree.
 Exam Practice Question 4 - Harris Bike Co. (HBC)
Harris Bike Co. (HBC) manufactures bicycles in large factory. Data suggest that there is a 45%
chance of the economy improving during the next three years, with a 35% chance of the
economy remaining unchanged, and a 20% chance of economic conditions worsening.
Hence, HBC is considering three growth options:
 Option 1: Launch a new line of foldable bikes, costing an estimated $2.5 million.
 Option 2: Build a new factory to increase the productive capacity of its existing bikes,
costing an estimated $4.5 million.
 Option 3: Diversify by building skateboards to add to its current product portfolio costing
an estimated $1.5 million.
The estimated costs and profit or loss of these options are shown below.

Option 1 Option 2 Option 3

Economic outlook
($2.5m) ($4.5m) ($1.5m)

Improves (45%) 5 8 3

Unchanged (35%) 3 5 2

Worsens (20%) 2 3 -1

(a) Construct a decision tree diagram for HBC and calculate the predicted outcome for each option.

(b) Based on your decision tree, comment on which option HBC should pursue.
Answers
(a) Construct a decision tree diagram for HBC and calculate the predicted outcome for each
option. [6 marks]

Award [1 - 2 marks] if there is some evidence of a general knowledge of decision trees, but it is not
accurately constructed. The calculations of each option are not all presented or are inaccurate.
Award [3 - 4 marks] if the main elements of the decision tree are constructed, but may not be entirely
accurate or the working may not be shown. For [4 marks], the calculations for each option are largely
correct and presented clearly.
Award [5 - 6 marks] if the decision tree is accurately constructed. The calculations of each option are
correct and well presented, with appropriate working out shown. For [6 marks], an appropriate key is
provided.

(b) Based on your decision tree, comment on which option HBC should pursue. [2 marks]
Findings shown in the decision tree suggest shows that HBC ought to pursue Option 2, i.e., build a
new factory to improve its productive capacity. Despite being the most expensive option, the
potential return of $8m is the highest of the three options, if the economy improves. Similarly, of the
3 options, even if the economy sees no change or improvement, the expected return from Option 2
is still the highest at $5m.
Award [1 mark] for an answer that shows some understanding of the demands of the question, but
without clear application of the data in the decision tree.
Award [2 marks] for an answer that shows clear understanding of the demands of the question, with
relevant use of the data in the decision tree.