Let's demonstrate how decision trees work in practice.

We assume that you are trying to decide whether to

invest $200,000 up front in a new retail outlet with a life of five years.

There's a 50% chance that the outlet will experience high demand in the first year,

in which case it would remain high for the remaining four years.

Each year, it would generate $150,000 per annum.

If demand is low in the first year, then it will remain low for

the remaining four years, generating only $50,000 each year.

So where is the option?

Well, the firm has the ability,

at the end of the first year, to expand operations in response to high demand.

Doing so will cost the firm $50,000 up front but

will increase subsequent annual cash flows to $170,000 per annum.

Let's assume a discount rate of 10% per annum, and further assume, for

the sake of the example, that all cash flows occur at year end.

Let's have a look at that decision tree.

So here is the decision tree.

The key with decision tree analysis is that before we can assess

the decisions that we face soonest, we must first reconcile the decisions that we

would make in the future depending upon the circumstances we find ourselves in.