USING

DECISION TREES

TO MANAGE

CAPITAL BUDGETING
RISK

BY JACK C. BAILES, PH.D., AND

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
capital budgeting risk for any indus-
try. In this article, we refer to the for-
est products industry to illustrate
how they are used.
Capital investments that forest products compa-
nies make are typically for equipment or timberland.
Among 29 forest products companies we surveyed,
69% of them said timberland accounted for 31% of
their total capital budget.1 To meet current and
future demand for raw material, forest products
companies purchase either timber or timberland.
Purchasing timberland begins with an initial cash
outflow and is followed by a series of net cash
inflows over as many as 20 years. (The revenues
emanating from the timber offset the purchase
costs.) The long-term nature of these decisions
means that time value of money is particularly
important, which is why discounted cash flow analy-
sis methods are so widely used for this type of deci-
sion. The long-term nature of these decisions,
however, also makes risk analysis an important issue
for forest products companies.
Decision-tree analysis is one method some of
these companies use to analyze capital budgeting
risk. First, a company attempts to outline several
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
expected profitability based on either the companys
cash flow or net income. The technique is particu-
larly useful in dealing with fluctuating timber prices.
In our survey, many of the respondents said that
noneconomic issues were becoming more important
in their decision-making process. The issue cited
most often was the changing regulatory climate in
the forest products industry, especially as it relates
to health, safety, and the environment. For this rea-
son, we will show how decision-tree analysis could
be used by forest products companies to evaluate
the economic consequences of alternative regulatory
scenarios.
A N I L L U S T R AT I O N OF DECISION-TREE
A N A LY S I S 2
One area of particular concern to forest products
decision makers is their current and future timber
supply. There is always the possibility that new
environmental regulations designed to protect habi-
tat for an endangered species would reduce the sup-
ply of timber available for harvest. A decision-tree
approach allows decision makers to look at how
alternative regulatory scenarios can affect the possi-
ble outcomes of a timber investment decision.
The Illustration. Assume Wood Products Compa-
ny is considering purchasing timberland that would
provide a future source of timber supply for the
companys operations over the next 10 years. Based
on current environmental regulations, the company
has forecasted present values using the most likely
future cash flows. These values are shown in Table
1. The current cost of buying the timberland is $5
million. The most likely present value of buying the
timber as needed is also calculated to be $5 million.
(For simplicity, this assumes that purchase cost
increases exactly offset the discount rate.) The
future cash flows from using the timber are estimat-
ed to have a present value of $6 million regardless of
whether the company buys the timberland today or
waits to purchase its timber as needed over the next
10 years. This means there is a $1 million net pre-
sent value (NPV) of either buying the timberland
now or buying the timber as needed. In other words,
from a financial standpoint, the two alternative tim-
ber acquisition strategies would be equal.
Now suppose, however, that the company
believes there is only a 60% chance that the envi-
Table 1: Net Present Values of Timber
Acquisition Alternatives
(Using the most likely cash flows to calculate present values)
Present Present
Value of Value of Net Present
Timber Cost Using Timber Value
Buy Timberland Now $5 Million $6 million $1 million
Buy Timber as Needed $5 Million $6 million $1 million
ronmental regulations affecting timber supply will
remain unchanged. Furthermore, the company
believes that there is a 30% chance these regulations
will become stricter during the next 10 years and
only a 10% chance that these regulations will be
relaxed. This one area of uncertainty leads to three
possible projected outcomes for the project instead
of only one. A decision tree is a way of diagramming
this type of uncertainty so that each branch of the
diagram represents one of the possible scenarios.
MANAGEMENT accounting quarterly 15
 Figure 1: Decision Tree Cuts a Trail Through Regulatory Uncertainty

Present Present Net

Environmental Value of Value of Present Expected
Regulation Probability Using Timber Timber Cost Value Value
Buy
Timberland Increased Regulation 30% $6.5 M $5.0 M $1.5 M $0.45 M
Now Current Regulation 60% $6.0 M $5.0 M $1.0 M $0.60 M
Decreased Regulation 10% $4.5 M $5.0 M $(0.5 M) $(0.05 M)
$1.00 M

Decision

Increased Regulation 30% $6.5 M $7.0 M $(0.5 M) $(0.15 M)

Buy Current Regulation 60% $6.0 M $5.0 M $1.0 M $0.60 M
Timber as Needed Decreased Regulation 10% $4.5 M $3.0 M $1.5M $0.15 M
Over the Next 10 Years $0.60M

Figure 1 shows the decision-tree diagram incorpo-
rating regulatory uncertainty. The data shown in this
diagram are taken from Tables 2 and 3. These data
reflect the scenarios that increased environmental
regulation would reduce the available supply of tim-
ber while reduced environmental regulation would
increase the available supply of timber. A reduction
in timber supply should cause an increase in both
the present value of future cash flows from using
the timber due to higher sales prices and an increase
in the present value of the cost of purchasing the
timber as needed. (Of course, the change in selling
price and buying cost may not necessarily be equal.)
Increases in the timber supply should have the
opposite effects.
The decision-tree diagram shows that the expected
value of the timberland purchase is $1.0 million com-
pared to an expected value of only $0.6 million from
buying the timber as needed. If Wood Products Com-
pany wants to maximize expected value, it should
purchase the timberland now. On the other hand, a
closer look at the decision tree shows that both deci-
sion alternatives offer a range of possible outcomes
depending on the level of environmental regulation.
If there is increased regulation, purchasing the
timberland now would provide the company with a
$1.5 million positive NPV compared to a $0.5 million
negative NPV of buying the timber as needed over
the 10 years. The net result would be a $2 million
advantage for purchasing the timberland now. If
environmental regulation is decreased, however, the
strategy of waiting to buy the timber would have the
$2.0 million net advantage. Only if current environ-
mental regulations continue unchanged would the
two alternatives have the same net present value.
PROS AND CONS OF DECISION-TREE
A N A LY S I S
The example above has been simplified to illustrate
the use of decision-tree analysis as a way of dealing
with uncertainty. In an actual project analysis, man-
agers will be concerned about several areas of uncer-
tainty such as regulation, inflation, the economy, and
export demand, for exampleall at the same time.
Each area of uncertainty will increase the complexi-
ty of the decision-tree analysis by adding another
series of branches to the diagram and another
dimension to the tables. If no attempt is made to
control the number of possible future events, deci-
sion trees can expand to the point that the analysis
becomes overwhelming for even the most sophisti-
cated manager.
On the other hand, the strength of decision trees
is that they allow the explicit analysis of possible
future events and decisions. By displaying the links
between todays and tomorrows decisions, they pro-

16 WINTER 2001
 Table 2: Present-Value Expectations Based on three regulatory scenarios

Level of Present Value Present-Value Present-Value

Environmental of Using Cost of Buying Cost of Buying
Regulation Probability Timber Timber as Needed Timberland Now
Increased Regulation 30% $6.5 million $7.0 million $5.0 million
Current Regulation 60% $6.0 million $5.0 million $5.0 million
Decreased Regulation 10% $4.5 million $3.0 million $5.0 million

vide additional insight into the

decision-making process and
Table 3: Net Present Values of Timber Acquisition Strategies
enable managers to make more
Based on three environmental regulatory scenarios
rational decisions today. Their
value should not be judged on Level of Net Present Value Net Present Value
their completeness or compre- Environmental of Buying of Buying
hensiveness but rather on Regulation Probability Timber as Needed Timberland Now
whether they show the most Increased Regulation 30% ($0.5 million) $1.5 million
important links between cur-
Current Regulation 60% $1.0 million $1.0 million
rent and future decisions.
Decreased Regulation 10% $1.5 million ($0.5 million)
C A P I TA L B U D G E T I N G A N D Expected Value $0.6 million $1.0 million
T H E F O R E S T I N D U S T RY
Historically, success in the for-
est products industry has been
measured on the basis of the bottom line. Has the implement, at least provide a framework in which to
firm been able to produce the financial results formally address some of these issues. Our recom-
required by its investors? As the number of stake- mendation is that forest products firms thoroughly
holders has increased, the old litmus test has investigate and begin to implement this and similar
changed. No longer is it possible for the company to procedures in their capital budgeting processes.
simply ignore its environmental and social responsi- Only those companies that do will stand tall in the
bilities in the pursuit of bottom line results. The 21st Century.
industry has traditionally spent approximately 10%
of its annual capital expenditures on pollution abate- Jack C. Bailes, Ph.D., is professor of accounting at the
ment. Most economists predict that the cost to com- College of Business, Oregon State University, Corvallis,
ply with environmental regulations for the forest Ore. He can be reached at (541)737-2517 or
products industry will increase in the future. bailes@bus.orst.edu.
In order to remain competitive in this capital
intensive industry, forest products companies will James F. Nielsen, Ph.D., is professor of finance at the
not only have to become efficient in their value- College of Business, Oregon State University. He can be
added activities, but they will also have to make reached at (541)737-3226 or nielsenj@bus.orst.edu.
economically sound, environmentally conscious, and
socially acceptable decisions. Implementing effec- 1 Jack Bailes, James Nielsen, Stephen Lawton,How Forest
Products Companies Analyze Capital Budgets, Management
tive capital budgeting practices will contribute to
Accounting, October 1998.
the companys ability to survive in this period of 2 For a detailed discussion of the use of decision trees in
transformation. capital budgeting, see James C. Van Horne, Financial
Capital budgeting methodologies such as deci- Management and Policy, 11th edition, Prentice-Hall, 1998,
sion-tree analysis, while not always ideal or easy to pp. 177-188.

MANAGEMENT accounting quarterly 17