Economics Capital Budgeting Questions Medium
In risk assessment for capital budgeting, there are primarily two types of decision trees that are commonly used: deterministic decision trees and probabilistic decision trees.
1. Deterministic Decision Trees: These decision trees are based on deterministic or certain outcomes. They assume that the future events and their outcomes are known with certainty. Deterministic decision trees are useful when the probabilities associated with different outcomes are not relevant or when the decision-maker wants to analyze the best-case and worst-case scenarios. In this type of decision tree, each branch represents a decision or event, and the associated outcome is known with certainty.
2. Probabilistic Decision Trees: Unlike deterministic decision trees, probabilistic decision trees consider the uncertainty associated with future events and their outcomes. They incorporate probabilities to represent the likelihood of different outcomes. Probabilistic decision trees are useful when there is uncertainty in the future events and their outcomes. Each branch in the tree represents a decision or event, and the associated outcome is assigned a probability. The probabilities are typically estimated based on historical data, expert opinions, or statistical analysis.
Both types of decision trees are valuable tools in risk assessment for capital budgeting. Deterministic decision trees help in analyzing extreme scenarios and identifying the best and worst possible outcomes. On the other hand, probabilistic decision trees provide a more realistic representation of the uncertainty involved in capital budgeting decisions by incorporating probabilities. By considering both types of decision trees, decision-makers can make more informed choices and assess the potential risks and rewards associated with different investment options.