Finance for Engineers

pp 427-456

Decision Tree Analysis and Utility Theory

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Two connected topics are discussed in this chapter: decision tree analysis and utility theory. Decision tree analysis is a graphical representation of the sequence of decisions, events and their anticipated outcomes. The graph consists of decision, event and terminal nodes linked by branches indicating either the choice of a decision or the outcome of an event node. This graphical representation allows decisions to be deconstructed into their components so that the analyst can easily view the options and the outcomes. The probability of each outcome is used to evaluate the preferred decision. An extended example is used to illustrate decision tree analysis. Utility theory is a way of accounting for a decision maker’s risk tolerance. The utility function describes the utility of an outcome at the point of indifference, that is, the point at which the decision maker is indifferent to the risky option or to the certain option. The value of an outcome is transformed into a utility by the utility function. The preferred option is that which maximizes the utility. The outcomes in the decision tree may be defined in terms of utility, which increases the scope of decision tree analysis by accounting for preference and risk tolerance.