6.3 Following steps should be followed to construct a decision tree.6.3.1 Define the investment proposed
6.3.2 List out the clearly identified alternative decisions
6.3.3 Indicate the decision points, chance events and other data
6.3.4 Locate on the tree branches, regarding projected cash flows,
probability distribution, expected PV etc.,
6.3.5 Analyze the results
6.3.6 Select the best alternative
6.4 The decision tree approach is specifically useful for handling sequential
investments. By looking into the tree we may think from the future to the
present to identify the unprofitable branches. The point is to eliminate
such unprofitable branches. This procedure will help us determine the
optimum decision at various decision points.- Utility theory
7.1 Perhaps the utility theory may indicate the level of risk preference by the
investors. Putting risk and return together in different combinations, the
focus will be more on risk. The risk aversion in the form of threat is more.
As risk points rise, the marginal utility for money decreases. A graph
must be prepared from the point of Zero risk and lowest return. This will
demonstrate the point at which a rational investor will try to maximize his
utility. The risk preferences of the decision maker are directly
incorporated in the capital budgeting analysis.