MULTI-STAGE DECISION-

MAKING PROBLEMS

DECISION TREE
- In analyzing multiple stage decision situations,
- we have to evaluate the decision proceeding in a
backward manner by evaluating the best course of
action at the later stages to decide the best action at
the earlier stages.
- For this purpose, the decision tree or the decision
flow diagram as it is sometimes called, is a very
effective device.
 Example:
• An oil company has recently acquired rights in a certain area
to conduct surveys and test drillings to lead to lifting oil if it is
found in commercially exploitable quantities.
• The area is considered to have good potential for finding oil in
commercial quantities.
• At the outset, the company has the choice to conduct further
geological tests or to carry out a drilling programme
immediately.
• On the known conditions, the company estimates that there
is a 70 : 30 chance of further tests showing a 'success'.
• Whether the tests show the possibility of ultimate success or
not or even if no tests are undertaken at all, the company
could still pursue its drilling programme or alternatively
consider selling its rights to drill in the area.
• Thereafter, however, if it carries out the drilling programme,
the likelihood of final success or failure is considered
dependent on the foregoing stages. Thus:
• if 'successful' tests have been carried out, the
expectation of success in drilling is given as 80 : 20.
• if the tests indicate 'failure', then the expectation of
success in drilling is given as 20 : 80.
• if no tests have been carried out at all, the
expectation of success in drilling is given as 55 : 45.
Costs and revenues have been estimated for all
possible outcomes and the net present value of
each is as follows:
 Outcome Net Present Value (Rs
million)
Success:
With prior tests 100
Without prior tests 120
Failure:
With prior tests -50
Without prior tests -40
Sale of exploitation rights:
Prior tests show 'success' 65
Prior test show 'failure' 15
Without prior tests 45
(a) Draw up a decision (probability) tree diagram to represent the above
information; and
(b) Evaluate the tree in order to advise the management of the company on
its best course of action
 Evaluation of Decision Node 1
Alternative Outcome Prob. Conditional Expected
Value Value

1. Drill Success 0.2 100 20

Failure 0.8 - 50 - 40

Total - 20
2. Sell 1.0 15 15

- The expected value of the drilling option is a loss of Rs 20

million while if the site is sold, we can get Rs 15 million.
- On the basis of the criterion of maximization of the expected
profit, our decision would be to sell the site, which is
conditional upon the negation indicated by the test
 Evaluation of Decision Node 2
Alternative Outcome Prob. Conditional Value Expected Value

l. Sell 1.0 65 65
2. Drill Success 0.8 100 80
Failure 0.2 - 50 - 10
Total 70

- The two alternative courses of action, namely selling and

drilling, have expected values equal to Rs 65 million and
Rs 70 million, respectively.
- Obviously, therefore, provided that a positive result is
indicated by the test, the best course would be to go in
for oil drilling
 Evaluation of Decision Node 3
Alternative Outcome Prob. Conditional Value Expected Value
1. Drill Success 0.55 120 66
Failure 0.45 -40 -18
Total 48
2. Test Positive 0.7 70 49.0
Negative 0.3 15 4.5
Total 53.5
3. Sell 1.0 45 45
- As we may observe, the expected value of the alternative of carrying out a test is
Rs 53.5 million, which is the highest of the three.
- Therefore, it is better to test before drilling.
- This is the initial decision.
- The overall decision can now be stated as: The test be carried out. If it proves
negative, the rights should be sold to give a return of Rs 15 million.
- To proceed with drilling, if that happens, would expectedly lead to a loss.
However, if the test proves positive, the drilling should be undertaken.