Professional Documents
Culture Documents
DECISION TREES
TO MANAGE
CAPITAL BUDGETING
RISK
J A M E S F. N I E L S E N , P H . D .
14 WINTER 2001
D
ecision trees can be used to manage approach allows decision makers to look at how
capital budgeting risk for any indus- alternative regulatory scenarios can affect the possi-
try. In this article, we refer to the for- ble outcomes of a timber investment decision.
est products industry to illustrate The Illustration. Assume Wood Products Compa-
how they are used. ny is considering purchasing timberland that would
Capital investments that forest products compa- provide a future source of timber supply for the
nies make are typically for equipment or timberland. companys operations over the next 10 years. Based
Among 29 forest products companies we surveyed, on current environmental regulations, the company
69% of them said timberland accounted for 31% of has forecasted present values using the most likely
their total capital budget.1 To meet current and future cash flows. These values are shown in Table
future demand for raw material, forest products 1. The current cost of buying the timberland is $5
companies purchase either timber or timberland. million. The most likely present value of buying the
Purchasing timberland begins with an initial cash timber as needed is also calculated to be $5 million.
outflow and is followed by a series of net cash (For simplicity, this assumes that purchase cost
inflows over as many as 20 years. (The revenues increases exactly offset the discount rate.) The
emanating from the timber offset the purchase future cash flows from using the timber are estimat-
costs.) The long-term nature of these decisions ed to have a present value of $6 million regardless of
means that time value of money is particularly whether the company buys the timberland today or
important, which is why discounted cash flow analy- waits to purchase its timber as needed over the next
sis methods are so widely used for this type of deci- 10 years. This means there is a $1 million net pre-
sion. The long-term nature of these decisions, sent value (NPV) of either buying the timberland
however, also makes risk analysis an important issue now or buying the timber as needed. In other words,
for forest products companies. from a financial standpoint, the two alternative tim-
Decision-tree analysis is one method some of ber acquisition strategies would be equal.
these companies use to analyze capital budgeting Now suppose, however, that the company
risk. First, a company attempts to outline several believes there is only a 60% chance that the envi-
different scenarios that might occur over the life of
the timberland project. The next step is to assign
probabilities to each scenario and then calculate Table 1: Net Present Values of Timber
expected profitability based on either the companys Acquisition Alternatives
cash flow or net income. The technique is particu- (Using the most likely cash flows to calculate present values)
larly useful in dealing with fluctuating timber prices.
In our survey, many of the respondents said that Present Present
noneconomic issues were becoming more important Value of Value of Net Present
in their decision-making process. The issue cited Timber Cost Using Timber Value
most often was the changing regulatory climate in
Buy Timberland Now $5 Million $6 million $1 million
the forest products industry, especially as it relates
to health, safety, and the environment. For this rea- Buy Timber as Needed $5 Million $6 million $1 million
son, we will show how decision-tree analysis could
be used by forest products companies to evaluate
the economic consequences of alternative regulatory
scenarios. ronmental regulations affecting timber supply will
remain unchanged. Furthermore, the company
A N I L L U S T R AT I O N OF DECISION-TREE believes that there is a 30% chance these regulations
A N A LY S I S 2 will become stricter during the next 10 years and
One area of particular concern to forest products only a 10% chance that these regulations will be
decision makers is their current and future timber relaxed. This one area of uncertainty leads to three
supply. There is always the possibility that new possible projected outcomes for the project instead
environmental regulations designed to protect habi- of only one. A decision tree is a way of diagramming
tat for an endangered species would reduce the sup- this type of uncertainty so that each branch of the
ply of timber available for harvest. A decision-tree diagram represents one of the possible scenarios.
Decision
Figure 1 shows the decision-tree diagram incorpo- the 10 years. The net result would be a $2 million
rating regulatory uncertainty. The data shown in this advantage for purchasing the timberland now. If
diagram are taken from Tables 2 and 3. These data environmental regulation is decreased, however, the
reflect the scenarios that increased environmental strategy of waiting to buy the timber would have the
regulation would reduce the available supply of tim- $2.0 million net advantage. Only if current environ-
ber while reduced environmental regulation would mental regulations continue unchanged would the
increase the available supply of timber. A reduction two alternatives have the same net present value.
in timber supply should cause an increase in both
the present value of future cash flows from using PROS AND CONS OF DECISION-TREE
the timber due to higher sales prices and an increase A N A LY S I S
in the present value of the cost of purchasing the The example above has been simplified to illustrate
timber as needed. (Of course, the change in selling the use of decision-tree analysis as a way of dealing
price and buying cost may not necessarily be equal.) with uncertainty. In an actual project analysis, man-
Increases in the timber supply should have the agers will be concerned about several areas of uncer-
opposite effects. tainty such as regulation, inflation, the economy, and
The decision-tree diagram shows that the expected export demand, for exampleall at the same time.
value of the timberland purchase is $1.0 million com- Each area of uncertainty will increase the complexi-
pared to an expected value of only $0.6 million from ty of the decision-tree analysis by adding another
buying the timber as needed. If Wood Products Com- series of branches to the diagram and another
pany wants to maximize expected value, it should dimension to the tables. If no attempt is made to
purchase the timberland now. On the other hand, a control the number of possible future events, deci-
closer look at the decision tree shows that both deci- sion trees can expand to the point that the analysis
sion alternatives offer a range of possible outcomes becomes overwhelming for even the most sophisti-
depending on the level of environmental regulation. cated manager.
If there is increased regulation, purchasing the On the other hand, the strength of decision trees
timberland now would provide the company with a is that they allow the explicit analysis of possible
$1.5 million positive NPV compared to a $0.5 million future events and decisions. By displaying the links
negative NPV of buying the timber as needed over between todays and tomorrows decisions, they pro-
16 WINTER 2001
Table 2: Present-Value Expectations Based on three regulatory scenarios