Decision Trees

1
Decision Trees Sensitivity Analysis in Capital
Budgeting

• Lecture 7

2
What is Risk Analysis?

• So far we talk about future cash flows with
  CERTAINTY.
• How much can we be sure of such cash flow
  occurrence?
• Risk managements is about answering question of
  WHAT IF?
• Decision Trees
• Sensitivity Analysis

3
Decision Tree

• Using Decision Trees to Manage Capital Budgeting
  Risk, by Jack C . Bailes and James F. Nielsen,
  Management Accounting Quarterly, Winter 2001

4
Whats the concern of forest products decision
makers?

• Acquiring Stable current and future Timber Supply
  at Stable Prices
• Alternatives
• Purchasing Timbers as needed
• Buying Timberland and Growing Timbers of their own

5
Comparison of Alternatives

• Buying Timbers as needed
• Low Initial Capital Investments
• Flexibility
• Unstable Timber Supply

• Buying Timberland
• High capital investment
• 31 of total capital budget
• Low flexibility
• 20 years of cash collection periods
• Possible additional costs
• Stable Timber Supply

6
Incorporating Risk

• What risks are there in Timber Industry?
• Economy Up and Down
• Weather Change
• Regulation Change
• Decision-tree analysis is one method some
  companies use to analyze capital budgeting risk

7
Decision-Tree Process

• Set Basic scenario
• Outline several different scenarios that might
  occur over the life of the project
• Assign probabilities to each scenario
• Calculate expected profitability based on either
  the companys cash flow or net income
• Determine the expected NPV of each scenario

8
Step 1 Basic Scenarios
Buy Now or Later
9
Step 2 Outline Scenarios
PV of Revenue
PV of Costs
Regulation
6.5M
Increase
5M
Buying Timber Land
6.0M
No Change
5M
4.5M
Decrease
5M
Increase
6.5M
7M
Buying Timber as Needed
6.0M
No Change
5M
4.5M
Decrease
3M
10
Step 3 Add probabilities
Three possible outcomeswith probabilities
11
3. Create decision tree and find expected values
12
4. Compare Expected NPV
13
Pros Cons

• The benefits of decision trees
• allow the explicit analysis of possible future
  events and decisions
• provide additional insight into the
  decision-making process
• enable managers to make more rational decisions

14
Pros Cons

• The example is article is simplistic there are
  many more potential areas of uncertainty and risk
  that could be considered
• Regulation
• Inflation
• Economic conditions
• Export demand
• Handling each area causes a jump in the
  complexity of the decision tree (more branches)
• If no attempt is made to control the number of
  possible future events, decision trees can expand
  to the point that the analysis becomes
  overwhelming for even the most sophisticated
  manager

15
Recap

• The goal for any company
• Economically sound, environmentally conscious,
  and socially acceptable decisions

• Decision trees provide a way to
• Incorporate risk factors
• Consider social and environmental factors
  explicitly

16
Sensitivity Analysis

• Sensitively analysis is intended to determine how
  sensitive our projections are to changes in
  assumptions
• Techniques range from simple to complex