Corporate Finance

Risk Analysis in Capital Investments 
 217

• Build a small plant during the introductory period, and expand quickly if the demand shoots up. Otherwise,
  competitive products will eat into the company’s market share.


• Maintain the small plant, if the demand is low during the introductory period.


• Build a big plant no matter what the market size. Furthermore, the new product is the company’s first
  major breakthrough, and the management is not sure what course of action is optimal.

This given example has an important message: the decision problem is not in terms of an isolated decision
or a sequence of decisions, but is a problem in terms of a tree of decisions. We can either define and describe
decision trees, and then draw one for a business situation; or we can show a decision tree and then describe
the method of drawing. Here we resort to the second method. The decision tree for the given problem is
shown in Exhibit 11.6. The tree is made up of nodes and branches. The action or decision forks are indicated
with square nodes, and chance events with round ones. Each branch represents an alternative course of ac-
tion or decision. So, a decision tree has action choices and results of action. The company’s executives have
estimated probabilities, costs and benefits of each course of action as follows:

Initially high demand, sustained high: 60 percent

Initially high demand, long term low: 10 percent

Initially low and continuing low: 30 percent

Initially low and subsequently high: 0

Exhibit 11.6 Decision tree

DECISION POINT 2
DECISION
POINT 1 2 YEARS High average demand

BUILD BIG

PLANT

High initial, low subsequent

Low average demand

High av. demand

Expand

plant Low av. demand

BUILD SMALL

PLANT

DEMAND

No change

in plant

High av.

demand

INITIALLY LOW

DEMAND Low av.

demand

2

1

INITIALLY HIGH

DECISION POINT CHANCE EVENT