Practice Flashcards
What is a decision tree?
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All Flashcards in Topic 6.6
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6.6.120 cards
What is a decision tree?
A diagram mapping choices, outcomes, probabilities and financial values β helps decide based on expected value, not gut feeling.
Choice diagram + probabilities
Read a decision tree: start from the ___ at the β‘
Left β follow branches to see options, then outcomes at chance nodes.
Left
Decision trees: β‘ = decision, β = chance, branches = ___
Options and outcomes with probabilities and financial values.
Options + outcomes
Two benefits of decision trees?
Visual (easy to see all options); quantitative (uses numbers); forces risk assessment; compares expected values.
Visual + quantitative + risk
Two limitations of decision trees?
Probabilities are estimates (may be wrong); ignores qualitative factors; complex; gives false precision.
Estimates + no qual + complex
Compare expected values β the highest is usually the best, BUT ___
Always consider qualitative factors and risk tolerance too.
Qual + risk tolerance
Square β‘ on a decision tree = ___
Decision node β a point where the manager makes a choice.
Decision point
EV = outcome Γ probability (sum all at each node)
Expected value calculation β multiply and add.
Multiply + add
When evaluating, don't just pick the highest EV β also discuss ___
Risk, stakeholders and non-financial factors.
Risk + stakeholders + non-financial
Circle β on a decision tree = ___
Chance node β a point where different outcomes can happen with probabilities.
Chance/outcome point
Decision trees give a 'false sense of precision' because ___
The calculations look exact but are based on estimated probabilities β garbage in, garbage out.
Estimates look precise
Benefits: visual, quantitative, forces ___
Risk assessment β managers must think about probabilities.
Risk assessment
Decision trees don't consider ___
Qualitative factors β ethics, reputation, morale, stakeholder impact.
Qualitative factors
At chance nodes, look at ___ and ___
Probabilities and payoffs β to calculate expected values.
Probabilities + payoffs
Probabilities at each chance node must add up to ___
1 (or 100%) β if they don't, something is wrong.
1.0
Limitations: estimates, ignores ___, false precision
Qualitative factors (ethics, reputation, morale).
Qualitative
Quick: β‘ = ___. β = ___
Decision node; Chance node.
Decision; Chance
Probabilities are ___, so EVs are only as good as ___
Estimates; the estimates used β they may be wrong.
Estimates; estimate quality
A risk-averse business may prefer ___ EV with more ___
Lower; certainty β safer option even if mathematically inferior.
Lower EV + more certainty
Expected value = outcome Γ ___
Probability β for each outcome, then sum all results at that node.
Probability
6.6.225 cards
Net expected value formula?
Net EV = Expected value β Cost of the option.
EV minus cost
EV = Ξ£ (outcome Γ probability). Net EV = EV β ___
Cost of the option.
Cost
Draw decision trees ___ to right, calculate ___ to left
Left; right β build the diagram forward, calculate backward.
Draw β , calculate β
The highest net EV is mathematically best, BUT consider ___
Reliability of probabilities, affordability of losses, stakeholder impact, ethics, risk appetite.
Reliability + loss + stakeholders + ethics
Expected value formula?
EV = Ξ£ (outcome Γ probability) β add up all outcomeΓprobability pairs at a chance node.
Sum of (outcome Γ prob)
Option A costs $50k, EV = $68k. Net EV?
$68k β $50k = $18,000 net expected gain.
$18,000
Option A: success $100k (0.6), failure $20k (0.4). EV?
EV = ($100k Γ 0.6) + ($20k Γ 0.4) = $60k + $8k = $68,000.
$68,000
Step 1: Start with a ___ on the left
Decision node (square β‘) β the starting choice.
Square β‘
'How much can the business afford to lose?' relates to ___
Risk tolerance β if failure means bankruptcy, even high EV may be too risky.
Risk tolerance
Draw left to right, calculate ___
Right to left.
Right to left
Compare ___ EVs to choose between options
Net EVs β accounts for the different costs of each option.
Net
Always check that probabilities at each node add to ___
1.0 β if not, there's an error.
1.0
Probabilities at each node must add to ___
1.0.
1.0
In 10-mark questions, use decision tree calculation PLUS ___
Qualitative evaluation β numbers alone aren't enough for top marks.
Qualitative evaluation
Mark rejected options with ___
Two diagonal lines across the branch β shows which option was NOT chosen.
Two diagonal lines
Highest net EV isn't always best if it's also the ___
Riskiest β a risk-averse business may prefer lower net EV with more certainty.
Riskiest
EV tells you the ___ financial return of each option
Weighted average β not what you'll definitely get, but the statistical expectation.
Weighted average
Always evaluate beyond numbers: discuss ___, ___, qualitative
Risk and stakeholders.
Risk + stakeholders
Why mark rejected branches?
Shows the examiner you understand the decision process β Nov 2024 markscheme awarded marks for this.
Marks for showing rejection
A risk-averse business prefers ___ EV with more ___
Lower; certainty/predictability.
Lower + certain
Don't just report the EV β also evaluate ___
Whether the probabilities are reliable and what qualitative factors matter.
Reliability + qualitative
Quick: Mark rejected branches with ___
Two diagonal lines.
Two lines
Show working in EV calculations for ___
Method marks β even if the final number is wrong.
Method marks
Calculate from the ___ side first, then move ___
Right (outcomes); left (to compare at decision node).
Right β left
Net EV shows the expected ___ from choosing that option
Net gain (or loss) β after accounting for the cost of the investment.
Net gain
Topic 6.6 study notes
Full notes & explanations for Decision trees
BM exam skills
Paper structures, command terms & tips
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