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CA Final · Advanced Financial Management · Advanced Capital Budgeting Decisions

Which statement correctly describes how a decision tree for a sequential capital investment is evaluated?

A decision tree is solved by folding back from the end of the tree. At chance nodes, compute the probability-weighted expected value; at decision nodes, choose the alternative with the best value. This captures optimal later-stage decisions, which a forward or myopic approach would miss.

  1. AStart at the first decision node and pick the branch with the highest immediate cash flow, moving forward
  2. BAt every chance node pick the branch with the highest payoff, and at every decision node take the probability-weighted average
  3. CWork backwards from the final outcomes, taking probability-weighted values at chance nodes and the best alternative at decision nodesCorrect
  4. DIgnore later-stage decisions and discount only the first-stage cash flows at the risk-free rate

Explanation

Decision trees are solved by rolling back from the terminal branches. At chance nodes the expected value is computed using probabilities, and at decision nodes management selects the alternative with the highest value. Option 2 reverses these two roles, which is the key error, and the forward-looking approach in option 1 ignores future choices.

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