Capital Budgeting under Risk and Uncertainties^149
begin with, it need not worry about a weak market and the consequent low level
capacity utilisation. However, if the market turns out to be strong it will have to build
another plant soon (and thereby incur a higher total outlay) in order to save itself from
competitive encroachment.
To analyse situations of this kind where sequential decision making in the face of risk
is involved, decision tree analysis is a useful tool. This section discusses the technique
of decision tree analysis.
Steps in Decision Tree Analysis
The key steps in decision tree analysis are:- Identifying the problem and alternatives
- Delineating the decision tree
- Specifying probabilities and monetary outcomes
- Evaluating various decision alternatives.
Identifying the Problem and Alternatives To understand the problem and develop
alternatives, information from different sources-marketing research, engineering studies,
economic forecasting, financial analysis, etc.-has to be tapped. Imaginative effort must
be made to identify the nature of alternatives that may arise as the decision situation
unfolds itself and assess the kinds of uncertainties that lie ahead with respect to
market size, market share, prices, cost structure, availability of raw material and power,
technological changes, competitive action, and governmental regulation.
Recognising that risk and uncertainty are inherent characteristics of investment projects,
persons involved in analysing the situation must be encouraged to express freely their
doubts, uncertainties, and reservations and motivated to suggest contingency plans and
identify promising opportunities in the emerging environment.
Delineating the Decision Tree The decision tree, exhibiting the anatomy of the
decision situation, shows:
l The decision points (also called decision forks) and the alternative options avail-
able for experimentation and action at these decision points.
l The chance points (also called chance forks) where outcomes are dependent on
a chance process and the and likely outcomes at these points.
The decision tree reflects in a diagrammatic form the nature of the decision situation
in terms of alternative courses of action and chance outcomes which have been
identified in the first step of the analysis.
A decision tree can easily become very complex and cumbersome if an attempt is
made to consider the myriad possible future events and decisions. Such a decision tree,
however, is not likely to be a very useful tool of analysis. Over-elaborate, It may
obfuscate the critical issues. Hence an effort should be made to keep the decision tree
somewhat simple so that the decision makers can focus their attention on major ìfuture
alternatives without being drowned in a mass of trivia. One must remember the advice