Decision Tree Approach:
The outstanding feature of this method is that it takes into account the impact of all probabilistic estimates of potential outcomes. In other words, every possible outcome is weighed in probabilistic terms and then evaluated A decision tree approach is pictorial representations in tree forms, which indicate the magnitude, probability and inter relationship-of all possible outcomes. We will adopt following procedure for risk analysis through decision tree approach:
(i) The first step is to draw diagram, which shows the structure of the problem. Decision trees are constructed from left to right. The branches represent the possible alternative decisions, which could be made, and the various possible outcomes, which might rise. While drawing decision tree, the decision points faced by the manager are represented with squares and chance events shown by circles.
(ii) The NPV for each branch is evaluated.
(iii) Joint Probabilities are calculated for each branch. Sum of joint probabilities of all branches should be equal to 1.
(iv) NPV for each branch (calculated as above) will be multiplied by joint probability of that branch, which gives Expected Net Present value for each branch.
(v) The sum of ENPV of all branches is treated as ENPV of the project.
Cumulative Probability:
When Project involves more than one stage e.g. Refineries and we are given cumulative probability for each stage. In that case we need to calculate individual probabilities for each stage. With the help of separate probabilities for each stage we may construct decision tree. Separate probabilities may be calculated as below:
(i) For first stage, we have probabilities for both outcomes i.e. Favorable & Adverse outcomes.
(ii) Calculation of probabilities for next stage and so on:
Probability of adverse outcome of next stage =
Cumulative Probability of adverse outcome at next stage
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Cumulative probability of adverse outcome at previous stage
Probability of Favorable outcome at next stage =
1 - Probability of adverse outcome as above