Question

Can you provide a step by step process on how to calculate the estimated value from a decision tree? Can you provide how to calculate the risk value from a decision tree?

Answer 1

Building the Decision Tree

In this scenario, you can either:

• Build the new software: To build the new software, the associated cost is $500,000.
• Buy the new software: To buy the new software, the associated cost is $750,000.

  Decision Tree Start

• Stay with the legacy software: If the company decides to stay with the legacy software, the associated cost is mainly maintenance and will amount to $100,000.

Looking at the options listed above, you can start building the decision trees as shown in the diagram. By looking at this information, the lobby for staying with the legacy software would have the strongest case. But, let’s see how it plans out.

The Buy the New Software and Build the New Software options will lead to either a successful deployment or an unsuccessful one. If the deployment is successful then the impact is zero, because the risk will not have materialized. However, if the deployment is unsuccessful, then the risk will materialize and the impact is $2 million. The Stay with the Legacy Software option will lead to only one impact, which is $2 million, because the legacy software is not currently meeting the needs of the company. Nor, will it meet the needs should there be growth. In this example, we have assumed that the company will have growth.

Calculating Expected Monetary Value for each Decision Tree Path

The diagram depicts the decision tree. Now, you can calculate the Expected Monetary Value for each decision. The Expected Monetary Value associated with each risk is calculated by multiplying the probability of the risk with the impact. By doing this, we get the following:

Decision Tree Complete

• Build the new software: $ 2,000,000 * 0.4 = $ 800,000
• Buy the new software: $ 2,000,000 * 0.05 = $ 100,000
• Staying with the legacy software: $ 2,000,000 * 1 = $ 2,000,000

Now, add the setup costs to each Expected Monetary Value:

• Build the new software: $ 500,000 + $ 800,000 = $ 1,300,000
• Buy the new software: $ 750,000 + $ 100,000 = $ 850,000
• Staying with the legacy software: $ 100,000 + $ 2,000,000 = $ 2,100,000

The calculation of risk value from decision tree

Analysis can take into account the decision maker's (e.g., the company's) preference or utility function, for example:

The basic interpretation in this situation is that the company prefers B's risk and payoffs under realistic risk preference coefficients (greater than $400K—in that range of risk aversion, the company would need to model a third strategy, "Neither A nor B").

Another example, commonly used in operations research courses, is the distribution of lifeguards on beaches (a.k.a. the "Life's a Beach" example).[4] The example describes two beaches with lifeguards to be distributed on each beach. There is maximum budget B that can be distributed among the two beaches (in total), and using a marginal returns table, analysts can decide how many lifeguards to allocate to each beach.

Source : Wikipedia