Decision trees and dealing with

uncertainty

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About this free course
This free course is an adapted extract from the Open University course B874 Finance for strategic
decision-making - www.open.ac.uk/postgraduate/modules/b874.
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Decision trees and dealing with uncertainty
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Contents
Introduction 4
Learning Outcomes 5
1 Dealing with uncertainty: an introduction to probability 6
2 Check your understanding of probability 10
3 Expected values 12
4 Decision trees 16
4.1 Decision trees and expected value 18
4.2 A complex decision tree – deciding whether or not to launch a product early
22
4.3 A complex decision tree – developing a new pharmaceutical drug 25
Conclusion 28
References 28
Acknowledgements 28

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Introduction

Introduction
This course is concerned with using decision trees to simplify and formulate business
decisions, typically using financial information. As decisions affect the future well-being of
an organisation, they almost always rely on some form of forecast information. In this
course, you will consider the subject of uncertainty in a financial context and meet a few
ways of dealing with it, including a basic introduction to probability. This will help you to
understand a common approach to dealing with financial information known as an
‘expected value’.
Once you have a basic understanding of probability, you will then use that knowledge in
the context of a powerful and sophisticated technique referred to as a ‘decision tree’. This
technique allows you to consider, simultaneously, a variety of possible outcomes and to
find the optimal decision for the organisation.

This OpenLearn course is an adapted extract from the Open University course
B874 Finance for strategic decision-making.

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Learning Outcomes
After studying this course, you should be able to:
● deal with basic uncertainty in a decision-making context
● understand the basic ideas of probability
● calculate expected values
● produce and analyse a decision tree.
1 Dealing with uncertainty: an introduction to probability

1 Dealing with uncertainty: an introduction

to probability
Allow approximately 1 hour 30 minutes to complete this section.

Decision-making is often undertaken in an uncertain world. That is, you might have some
doubts about the reliability of the data you have been provided with, as well as the future
environment in which you will be operating. In business, uncertainty regarding the future
can cover a very wide range of scenarios, including:

● political – who will be running the country in five years’ time? What will be their view
on, for example, tax, regulation, etc.?
● economic – will the country be in recession, or booming? What will interest rates be?
● market – how will your product market develop? Will there be new entrants, leavers
or substitutes?

As decision-makers, you need to find strategies to deal with uncertainty and so, in this
section, you will be introduced to the topic of probability.
A knowledge of probability enables you to assess the likelihood of something happening.
For example, what is the chance that a 55-year-old person will buy a new car in the next
12 months?
You might subdivide the data – what is the probability that a 55-year-old man will buy a car
within the next 12 months?
You can then go further by attaching conditions. For example, what is the probability that a
55-year-old man, who bought his last car three years ago, will buy a new car within the
next 12 months?
Or even, if a 55-year-old man has purchased a new car within the last three years, how
long will it be before he buys a new car?
Unfortunately, probability theory is quite a complex subject and so in this course you will
only consider the most basic ideas. These ought to suffice for the kinds of decisions that
managers need to make most of the time. In the next activity you will be introduced to
those basic ideas.

Activity 1 What is probability?

Allow approximately 20 minutes to complete this activity

In Videos 1 and 2, you will be introduced to the basic ideas of probability. An

understanding of probability allows you to quantify uncertainty.
You will build on your understanding of probability, especially later on in this course
when you learn about decision trees. So you may need to watch Videos 1 and 2 a few
times until you feel comfortable with how probability starts to address the question of
how to deal with uncertainty in decision-making.

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1 Dealing with uncertainty: an introduction to probability

Part 1
Watch Video 1. You may like to make notes in the text box below.

Video content is not available in this format.

Video 1 An introduction to probability: part 1

Provide your answer...

Part 2
Watch Video 2. You may like to make notes in the text box below.

Video content is not available in this format.

Video 2 An introduction to probability: part 2

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1 Dealing with uncertainty: an introduction to probability

Provide your answer...

Discussion
From Video 2 you learnt that probability is a way of measuring uncertainty. The
probability of an event may be taken as the proportion of times that an event can occur
out of the total possible events. The video provided some simple examples of how you
might estimate a probability.

Most people will have an instinctive feel for what probability is. Probability is a measure
of how likely it is that something will occur. How might you assess that likelihood?
Probability: first principles
To begin, you might be able to derive a number from first principles.
For example, it is hopefully obvious that if someone throws a ‘normal’ six-sided die, the
number ‘3’ is likely to land face up 1 in 6 times. You might say that the probability of
throwing a ‘3’ is , or one sixth.
Of course, if someone throws a die six times then they might get ‘3’ more than once or
even no ‘3’s. It is only if the die is thrown thousands of times that the person will notice that
roughly one sixth of the throws result in a ‘3’ landing face up.
Probability: considering past behaviour
Another way of arriving at a probability might be to observe past behaviour. For example,
the Eurovision song contest has, as of April 2019, had 66 winners (some years there have
been joint winners). The Republic of Ireland has won it seven times. So you might
conclude that the Republic of Ireland has a probability of winning the next contest. Coming
to such a conclusion is, of course, rather simplistic. You would need to consider how much
past success indicates the chance of future success, given that the performers are usually
different.

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1 Dealing with uncertainty: an introduction to probability

Probability: subjective opinion

One last way you might assign a probability is through simply expressing a subjective
opinion. For example, if you watch the Eurovision performers prior to voting, you might
arrive at a view of which act is most likely to appeal to the voters (nowadays, a
combination of the public and appointed judges). Of course, this probability might be very
different to that assigned by another watcher.
The concept of probability could also be used to consider how the gambling industry
functions and the interplay between odds and subjective probabilities, but this will not be
covered in this course.

In business scenarios, it is not often that you can rely on the first approach of deriving a
number from first principles of probability only. More often, you have to arrive at a
probability based on a combination of some data (via a market survey, for example)
and experience.

Before proceeding, the definition and mathematical rules for probability need to be
explained. From the die example earlier, a reasonable definition of a probability can be
concluded as follows:

● Probability is expressed as a ratio whose value is positive. You cannot have

negative probabilities.
● A probability is less than or equal to 1. This means that a probability cannot
exceed 1.
● The total of all probability outcomes must equal 1.
For example, if the probability of something happening is 0.45, the probability of it
not happening must be .

In the next section you will have the opportunity to check your understanding of
probability.

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2 Check your understanding of probability

2 Check your understanding of probability

Allow approximately 30 minutes to complete this section.

In this section, you will attempt some questions and work through examples to test and
embed your understanding of basic probability, as used in decision-making. First, try
some simple questions on probability in Activity 2.

Activity 2 Probability quiz

Allow approximately 5 minutes to complete this activity

Select the response that best answers each question.

1. What does a probability of 1 mean?
¡ This means that the event is certain to occur.
¡ There is a 1 in 100 chance of the event occurring.
¡ The event can only occur once.
¡ There is a 1 in 10 chance of the event occurring.
2. What must all the probabilities of all outcomes total to?
¡ They must total to 1.
¡ The total value of all outcomes.
¡ 0.50.
¡ It depends on the event.

Now study the following worked example in Box 1.

Box 1 Worked example on probability

What is the probability of throwing three heads and one tail, when throwing four coins at the
same time?
To answer this, you need to explore the total number of possible outcomes. Here are two
approaches to this problem.

Approach 1

Each coin will fall independently. The possible combinations are as follows. (Note that
the scenarios of ‘three heads and one tail’ are in bold and italics below.)
HHHH
HHHT
HHTH
HHTT
HTHH
HTHT
HTTH
HTTT

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2 Check your understanding of probability

THHH
THHT
THTH
THTT
TTHH
TTHT
TTTH
TTTT
From the list of possible combinations, you can conclude that there are 16
combinations, four of which (in italics) are three heads and one tail. This can be
shown as:

Approach 2

The number of combinations could also have been found as follows:

● each coin has two possible outcomes

If the first coin has two possible outcomes and the second also has two, then
between them there are four combinations (i.e. 2 × 2 = 22 = 4)
● adding a third coin (which has two outcomes) doubles the combinations
(i.e. 2 × 2 × 2 = 23 = 8)
● finally, the last coin makes it 16 (i.e. 24) as there are 4 coins, each of which may be
heads or tails, then there are 4 combinations with 3 heads and one tail, so, the
probability is: .

In Activity 3, you will apply your understanding of probabilities in considering a different

scenario.

Activity 3 Probability of ribbons in a box

Allow approximately 10 minutes to complete this activity

You place five ribbons in a box. They are coloured, black, blue, red, yellow and green.
If you pull out two ribbons and the first is black, what is the probability that the second
you select is blue?

Provide your answer...

Answer
The probability of the second ribbon selection being blue is then:

You have now covered the basic ideas of probability and for the rest of this course you will
learn how to apply these ideas in the context of making business decisions.

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3 Expected values

3 Expected values
Allow approximately 1 hour to complete this section.

You can use probability to arrive at a weighted average of the value of an outcome,
reflecting the various levels of likelihood. This weighted average can be called the
expected value. Work through the following example to see how this idea is used in
financial forecasting.

Box 2 Worked example on forecasting interest rates

Economic forecasters are unsure what interest rates will be next year. However, combining
the various contributing economic scenarios, they believe the outcomes shown in Table 1
are possible.

Table 1
Probability of
different possible
interest rates
Possible Probability
interest
rate %
1.50 0.29
2.75 0.54
3.90 0.17

Note that there are only three possible outcomes.

Their probabilities must total one.
So, .
The ‘expected value’ of interest rates can be calculated as follows:

As a common sense test, note that the expected value is close to the overwhelmingly most
probable (2.75%, with a probability of 0.54).
Also, the expected value, being an average, must lie within the range of possible outcomes
(that is, between 1.5% and 3.9%).

In the next activity you will use the idea of expected value to estimate stock returns.
Although this approach may seem simplistic, it lies at the heart of modern-day corporate
finance.

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3 Expected values

Activity 4 Calculating the expected value of stock returns

Allow approximately 15 minutes to complete this activity

In this activity, you will calculate the expected value of stock returns. You will assume
that the rates of return on the stock market over the last 120 years are as summarised
in Table 2. The frequency tells you how many of those years a particular return was
made.

Table 2
Frequency of
stock returns
Return Frequency
%
3.00 4
3.25 12
4.00 19
4.50 23
5.12 28
6.00 18
6.50 12
7.00 4
120

Part 1 Calculating the probability of stock returns

Before you calculate the expected value of stock returns, you will first need to find the
probabilities and record them in Table 3.
Hint: if something occurs 4 times out of 120, what is its probability?

Table 3 Calculating the probability of

stock returns
Return Frequency Probability
%
3.00 4 Provide your answer...

3.25 12 Provide your answer...

4.00 19 Provide your answer...

4.50 23 Provide your answer...

5.12 28 Provide your answer...

6.00 18 Provide your answer...

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3 Expected values

6.50 12 Provide your answer...

7.00 4 Provide your answer...

120 Provide your answer...

Tip: do not forget to check that all of the probabilities add up to a total of one.

Answer
So, taking 3.00% as an example from Table 2, you can see that it has occurred four out
of a possible total 120 times. This gives it a probability as follows: .
If you then calculate the probability for all of the stock returns, you should get the
results shown in Table 4.

Table 4 The probability of

stock returns
Return Frequency Probability
%
3.00 4 0.0333
3.25 12 0.1000
4.00 19 0.1583
4.50 23 0.1917
5.12 28 0.2333
6.00 18 0.1500
6.50 12 0.1000
7.00 4 0.0333
120 1.0000

Part 2 Calculating the expected value of stock returns

You can now calculate the expected value of stock returns and complete Table 5.

Table 5 Calculating the expected value of stock

returns
Return Frequency Probability Expected value
%
3.00 4 0.0333 Provide your answer...

3.25 12 0.1000 Provide your answer...

4.00 19 0.1583 Provide your answer...

4.50 23 0.1917 Provide your answer...

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3 Expected values

5.12 28 0.2333 Provide your answer...

6.00 18 0.1500 Provide your answer...

6.50 12 0.1000 Provide your answer...

7.00 4 0.0333 Provide your answer...

120 1.000 Provide your answer...

Answer
To get the expected value of stock returns, you multiply each stock return by its
probability and then sum the result, as shown in Table 6 below.

Table 6 Expected value of stock returns

Return Frequency Probability Expected
% value
3.00 4 0.0333 0.100
3.25 12 0.1000 0.325
4.00 19 0.1583 0.633
4.50 23 0.1917 0.863
5.12 28 0.2333 1.195
6.00 18 0.1500 0.900
6.50 12 0.1000 0.650
7.00 4 0.0333 0.233
120 1.000 4.899

So the expected value of stock returns is 4.899%, which you could round up to 4.9%.

You will use expected value in the next section on decision trees.

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4 Decision trees

4 Decision trees
Allow approximately 2 hours to complete this section.

Sometimes decisions can be complex and require a number of stages to arrive at a final
outcome. Such a final outcome may be dependent on earlier, intermediate decisions.
Alternatively, the final decision may be dependent on a series of uncertain, intermediate
outcomes. Dealing with these types of decisions may appear, on the face of it, quite
difficult. However, the technique of decision trees that you are going to explore in this
section will help to simplify this process.
The best way to illustrate the technique is by a worked example in Activity 5. Before doing
so, it is important to point out the meaning of two symbols that will be used in the decision
trees.
Where a branch appears on your tree, this point will be called a node. A node may appear
for one of two reasons. The first is that a decision is required. In other words, the node
represents a series of choices. This type of node will be called a decision node and a
square will be used to denote it. The second type of node is a chance node. Here, there
is a range of possible events or outcomes of varying probabilities. Such nodes are
denoted with a circle.

Activity 5 Introduction to decision trees

Allow approximately 30 minutes to complete this activity

In Videos 3 and 4, you will be introduced to the powerful technique of decision trees.
This technique allows you to incorporate probabilities into a range of potential
outcomes, which may themselves be conditional on other outcomes.
You may wish to watch the videos a few times and make notes in the text boxes to
ensure that you understand the concept of decision trees, as well as to answer the
questions.

Part 1
A company (MKOU) is assessing two outsourcing bids, A and B. Company A is more
expensive but is reckoned to have a higher probability of delivering a high quality good
than B. This is important as the higher the quality the more MKOU can charge and the
less it will need to refund to dissatisfied customers. The data may be summarised as
shown in Table 7.

Table 7 Possible financial benefits of

using companies A and B
Company Probability Net Net
of financial financial
acceptable benefit if cost if not
service acceptable acceptable
level £M £M
A 80% 120 -30
B 55% 160 -10

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4 Decision trees

Video content is not available in this format.

Video 3 A worked example on decision trees

Provide your answer...

Part 2
A company is considering launching a new product. It can either launch immediately or
in one year’s time. If it launches immediately there is a 0.75 chance of the launch being
successful. If it is unsuccessful then the launch will be halted at a cost of £1M and
relaunched in a year’s time. If the company launches immediately it may opt to also
have a promotion, which has a 0.6 chance of success. If the promotion is successful
the financial benefit is £10M, if not £2M. If the company does not do the promotion the
benefit is £5M. If the company launches in a year’s time the benefit is £6M. What
should the company do?

Video content is not available in this format.

Video 4 A second worked example on decision trees

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4 Decision trees

Provide your answer...

Discussion
To summarise, you can use decision trees to break down a decision into a series of
events that involve the decision-maker making a sub-decision (‘decision node’) or
there being a chance event outside of the decision-maker’s control (‘chance node’).
(Note that ‘sub-decision’ means a decision taken after the first, main, decision.)
By allocating probabilities to the chance nodes you can evaluate the expected value
from the various combinations of sub-decisions and chance events.
This then informs which initial decision and then subsequent sub-decisions should be
taken.

Now that you have watched the videos on decision trees, you will consider potential
decisions faced by businesses. In the next section you will see some more applied
examples of how decision trees are used in making business decisions.

4.1 Decision trees and expected value

You are now at a stage to see how an understanding of expected values and probability
can be combined to simplify complex business problems.

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4 Decision trees

Example: decision tree for a business considering a

new office location
You are considering opening a new office somewhere in the UK and you have shortlisted
two town councils: A and B. However, a key factor is the impact of local taxes, also called
business rates.
Local elections are coming up with two main parties in the running: J and K. Each party
has a different view on how business should be treated; however, there is uncertainty as
to whether they will increase or decrease business rates.
Table 8 shows the probabilities of each party winning, their possible views towards
business and the impact of each.

Table 8 Probabilities of each party

Council Party Probability Probability of Estimated impact Estimated impact of
of winning being of being business being business
business friendly/ £M unfriendly/ £M
friendly

A J 0.55 0.7 3.0 -0.50

K 0.45 0.4 0.5 -2.00
B J 0.30 0.6 2.5 -0.25
K 0.70 0.35 1.0 -1.00

The probabilities of winning might be based, for example, on the odds currently being
offered by a betting website, predicting the chances of that party winning.
The probabilities of being business friendly would be based on past experience and any
announcements being made by the parties.
The final two columns show the estimated monetary impact, positive or negative, in £
millions.
In the fifth column, ‘Estimated impact of being business friendly/£M’, if, for example, in the
first row, in council A, party J has a 0.7 probability of being business friendly, then it must
have a probability of 0.3 of being unfriendly towards business. This is because the total
probabilities must total to 1.
Table 8 includes estimates of the financial impact. So, for example, in the first row, it has
been estimated that in council A, if party J were business friendly, the company would
benefit financially by £3M. On the other hand, if the party were not business friendly, the
company would suffer financially by £0.5M.
The data shown in Table 8 can be mapped in a decision tree as follows.

Creating a decision tree

1. Put in the main decision and choice nodes (Figure 1).

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4 Decision trees

Figure 1 Decision tree for which council

2. Add the final column (Figure 2). This column leads to the final value for each
particular path. In other words, you will add the top branch of the decision tree – the
impact if council A wins and it is business friendly.

Figure 2 Decision tree for which council, with 'yes'/'no' chance nodes
3. Put in the impact values (Figure 3).

Figure 3 Decision tree for which council, with terminal values added
4. Then add their probabilities. Note that if party J in council A has a 0.7 probability of
being business friendly, then it must have a 0.3 (1 – 0.7) probability of being business
unfriendly.
As the only possibilities are being friendly or unfriendly, the probabilities of these
must equal 1 – it is definitely either friendly or unfriendly (Figure 4).
This example only has one decision node: which town to move to. There are then two
sets of chance nodes. The ‘chances’ being those actions outside of the decision-
maker’s control. They are: Which party will win? (So you can create a branch for
each of the two possibilities) and, is that winning party business-friendly or not?
Again, you create a branch for each answer. If there were more decisions, at each
decision node you would insert a branch for each option open to the decision-maker.

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4 Decision trees

Figure 4 Decision tree for which council, with probabilities added

Calculating the expected value

Now you can find the expected value of the financial impact for each party in each council.

■ What is the expected value of the financial impact if party J won in council A?
� There is a 0.7 probability of it being business friendly and 0.3 of it being unfriendly. If
party J won council A, the expected financial impact would be:
(0.7 × £3M) + (0.3 × -£0.5M) = £1.95M.
The expected values can be added to the decision tree (Figure 5).

Figure 5 Decision tree for which council, with expected values added to ‘Friendly’
nodes

■ What is the financial impact if the company moved to council B?

� There is a 0.3 probability of J winning (with an expected financial impact of £1.4M)
and 0.7 of K winning (with an expected impact of -£0.3M). So the expected financial
impact of moving to B is:
(0.3 × £1.4M) + (0.7 × -£0.3M) = £0.21M.
The probabilities can be added to the decision tree (Figure 6).

Figure 6 Decision tree for which council, with win probabilities and win node
expected values added

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4 Decision trees

For example, for council A, the expected value is:

(0.55 × £1.95M) + ( 0.45 × -£1M) = £0.62M

So now you can step back and see that council A has the higher expected value (£0.62M
compared with £0.21M in B) and so, on the grounds of economic impact (there may be
other factors), you would select to relocate to A.
This general approach to solving the problem, by analysing from the last stage back to the
first, is a process called dynamic programming. The content of this course will not go
beyond decision trees.
In the next subsection you will consider an example of a complex decision tree related to
the launch of a product.

4.2 A complex decision tree – deciding whether or

not to launch a product early
From the last worked example, you should now have a good understanding of the basics
of how decision trees work. In this next example in Activity 6 you will meet a more complex
decision tree with more than just the initial decision node. In other words, more than one
decision will be needed. Thus, as well as providing an initial decision (what to do now), the
decision tree will also provide a strategy for future decisions depending on the outcomes
of various chance events.

Activity 6 Example of a complex decision tree: considering early

launch of a product
Allow approximately 45 minutes to complete this activity

A company is planning on launching a new product. It was thinking of launching in

June of next year but it believes that a rival is also considering launching a similar
product around that time. The company is considering bringing the launch forward to
the end of this year. This will cost an extra €3M to carry out and the company believes
it will have a 0.8 probability of beating the rival to the market. If, however, they wait until
June, the probability of beating the rival falls to 0.2.
To make the decision easier, the company assumes that sales will be either high,
medium or low. If the company launches before its rival, the probability of high sales is
0.6 and the probability of medium sales is 0.25. If it launches after its rival, the
probability of high sales falls to 0.35 and medium sales rises to 0.45. If the rival
launches first, the company could undertake a sales promotion, costing €1.5M, but
would change the probabilities of high sales to 0.5 and medium to 0.4.
The financial impacts are that high sales would be worth €9M, medium would be worth
€5M and low, €1M.
Using a decision tree analysis, calculate what the company’s investment strategy
should be. You can use pen and paper, an Excel spreadsheet, or record your
calculations in the text box below.
Once you have arrived at a solution, watch Video 5 for the feedback of this activity.

Provide your answer...

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4 Decision trees

Discussion
Now watch Video 5.

Video content is not available in this format.

Video 5 Solution for considering the early launch of a product

You may find it useful to work through the written solution below too. In this more
complex decision tree you had to make some subsequent decisions based on the final
outcomes of each branch. Thus you not only arrived at an initial decision (what action
to take now) but also what actions to take at future points based on future chance
events.

Written solution
You can also read the solution below.
The decision tree is shown in Figure 7.

Figure 7 Decision tree: a company deciding on when to launch a new product

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4 Decision trees

The calculations for each node are as shown in Table 9 (remember that you will need
to work from right to left).

Expected sales

Table 9 Expected sales

Sales’ node number (from top to Expected sales – calculation €M Expected sales
bottom of decision tree) – value €M

1 (0.6 × 9) + (0.25 × 5) + (0.15 × 1) 6.8

2 (0.5 × 9) + (0.4 × 5) + (0.1 × 1) 6.6
3 (0.35 × 9) + (0.45 × 5) + (0.2 × 1) 5.6
4 (0.6 × 9) + (0.25 × 5) + (0.15 × 1) 6.8
5 (0.5 × 9) + (0.4 × 5) + (0.1 × 1) 6.6
6 (0.35 × 9) + (0.45 × 5) + (0.2 × 1) 5.6

Expected sales after promotion

There are two promotion decision nodes, as summarised in Table 10.

Table 10 Expected sales after promotion

Promotion node number (from Expected sales after Expected sales after
top to bottom of decision tree) promotion – promotion – value €M
calculation €M
1 – Yes 6.6 – 1.5 5.1
1 – No 5.6 5.6
2 – Yes 6.6 – 1.5 5.1
2 – No 5.6 5.6

At both decision nodes, the expected value of sales is higher without the promotion
than with it. The company will, therefore, never promote if launching after its rival. The
higher figure of expected sales (€5.6m) is now carried forward.

Table 11 Expected sales at 'Beat rival?' chance node

‘Beat rival’ node number (from top to Expected sales – Expected sales
bottom of decision tree) calculation €M – value €M

1 [(0.8 × 6.8) + (0.2 × 5.6)] − 3 3.56

2 (0.2 × 6.8) + (0.8 × 5.6) 5.84

You can see from Table 11 that the value of launching early is €3.56M, whereas the
value of not launching early is €5.84M.
Thus, the decision is two-fold: the company should not launch early. If it then finds that
it has not beaten its rival, it should not undertake a promotion.

In the next subsection you will consider another example of a complex decision tree, this
time related to the launch of a new pharmaceutical drug.

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4 Decision trees

4.3 A complex decision tree – developing a new

pharmaceutical drug
Now that you have watched Video 5 that presents a more complex example of using
decision trees, the next activity will give you an opportunity to practise the skill of building
and evaluating a decision tree.

Activity 7 Example of a complex decision tree: considering the

development of a new pharmaceutical drug
Allow approximately 30 minutes to complete this activity

A pharmaceutical company is considering developing a new drug. The key decision

criteria is the development time, which the company would like to minimise. There are
two approaches to developing the drug. The first is to base it on stem cell research
(‘stem’). There is a 0.4 probability that this approach would lead to a drug within 5
years, otherwise it will take up to 7 years (0.6 probability). Note, these times are from
the start of the use of this approach.
An alternative approach is based on a method called targeted delivery (‘TD’). This has
a 0.3 probability of delivering a drug within 3 years. However, if at the end of 3 years
there is no drug, the company would have to choose between switching to stem or
carrying on with TD. At that point, the TD will have a 0.8 probability of delivering the
drug within a further 2 years.
Although, if the drug has still not been delivered after a further 2 years, the company
can still switch to the stem approach. Alternatively, persevering at this stage with TD
will definitely yield a drug after a further 7 years.
Given the objective is to minimise development time, use a decision tree to determine
what the company’s strategy should be.
You can use pen and paper, an Excel spreadsheet, or record your calculations in the
text box below.

Provide your answer...

Discussion
First, you should draw the decision tree. Your decision tree should look something like
Figure 8 below.

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4 Decision trees

Figure 8 Decision tree: a company deciding on the development of a new

pharmaceutical drug
As before, you start from the right-hand side and work back towards the start.
At node G, the expected development time from that point is (0.4 × 5) + (0.6 × 7) = 6.2
years. Note that this is the development time for stem, so you can use this calculation
again.
As this is shorter than the alternative (7 years), at decision node F you would choose to
start the stem approach, taking 6.2 years from that point. However, you have already
waited 2 years before making that choice. From node E, there are 8.2 years (6.2 + 2) if
you follow the lower branch (leading to node F).
So from node E you have an expected development time of
(0.8 × 2) + (0.2 × 8.2) = 3.24 years.
You know that node D has an expected development time of 6.2 years (the stem time).
At node C you would choose to carry on with TD as the expected time is lower (3.24
years). However, it has taken you 3 years to arrive at node C, so the development time
is 6.24 years.
At node B, then, the expected development time is (0.3 × 3) + (0.7 × 6.24) =
5.27 years.
Now you have the strategy. As the first decision stem has an expected development
time of 6.2 years, whereas the first decision TD has an expected development time of
5.27 years.
Thus, you would start on TD. If after three years you had not developed the drug (now
at node C), you would choose to carry on with TD as the expected time at that point of
3.24 years is less than stem (6.2 years).

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4 Decision trees

If after a further two years you still had not developed the drug (at node F), you would
switch and start the stem approach, as 6.2 expected years for the stem approach is
less than the definite 7 years it would take to complete the TD approach.

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Conclusion

Conclusion
In this course, you learned how to use probability to quantify uncertainty. Probability
enables the decision-maker to calculate a quantity called the expected value, which gives
you a quantity that takes account of the differing probabilities of the potential outcomes of
an event.
Finally, you learned how to use these ideas in situations where there is a range of possible
outcomes, some of which may be dependent on earlier outcomes. The technique used
was that of a decision tree.
This OpenLearn course is an adapted extract from the Open University course
B874 Finance for strategic decision-making.

References
The Yale Tribune (2020) Mergers are on the Rise: Is it Good for the Economy?. Available
at: https://campuspress.yale.edu/tribune/mergers-are-on-the-rise-is-it-a-good-thing-for-
the-economy/ (Accessed: 2 September 2020).

Acknowledgements
This free course was written by Kevin Amor. It was first published in December 2020.
Except for third party materials and otherwise stated (see terms and conditions), this
content is made available under a
Creative Commons Attribution-NonCommercial-ShareAlike 4.0 Licence.
The material acknowledged below and within the course is Proprietary and used under
licence (not subject to Creative Commons Licence). Grateful acknowledgement is made
to the following sources for permission to reproduce material in this free course:

Images/Tables
Course/ Introduction image: Making decision: Photo by Vladislav Babienko on
Unsplash.

Audio/Video
Every effort has been made to contact copyright owners. If any have been inadvertently
overlooked, the publishers will be pleased to make the necessary arrangements at the
first opportunity.
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