Decision Trees

Updated January 2, 2015 by Matt H. Evans

Too often Financial Managers rush into a capital project by simply analyzing the cash flows. Since high levels of uncertainty are associated with most capital projects, the first place to start is with an analysis of the decision itself. Decision Trees are extremely useful for mapping-out a decision so that all alternatives are considered in relation to probabilities. Decision trees walk you through the different stages and events within the project. Expected values are calculated and a logical outcome is presented for making the right selection.

Several computer programs are available to automate the decision making process. Two popular programs are InfoHarvest ( www.infoharvest.com ) and Expert Choice ( www.expertchoice.com) . These programs allow you to build a tree through each period of your capital project. This process can be particularly useful when certain events are conditional on other events. Finally, decision tree programs can be used for all types of applications, such as make or buy decisions, marketing decisions, technology decisions, etc. If you are interested in a structured approach to decisions with high levels of uncertainty, decision trees can be invaluable.