3.3 Decision-making Techniques

Question 1

What are the three techniques involved in forecasting future sales?

Answer 1

Moving averages
Extrapolation
Correlation

Question 2

What are the main limitations of quantitative sales forecasting techniques?

Answer 2

Rely on the future being like the past.
Rely on correct interpretation of data.

Question 3

What are the three methods of investment appraisal?

Answer 3

Payback period
Average rate of return (ARR)
Net present value (NPV)

Question 4

When does payback occur?

Answer 4

When cumulative cash flow reaches zero.

Question 5

What is the formula for calculating payback?

Answer 5

Payback = outlay outstanding / monthly cash flow in year of payback

Question 6

What do payback calculations show?

Answer 6

The length of time that the money invested is ‘at risk’.

Question 7

What are the three steps involved in calculating the average rate of return?

Answer 7

1 Calculate total profit over lifetime of project, adding all net cash flows and deducting initial outlay.
2 Divide by the number of years the project lasts (average annual profit).
3 Divide by initial outlay and x100.

Question 8

What is the formula for average rate of return?

Answer 8

(Average rate of return / initial outlay) x 100

Question 9

What does a high ARR figure show?

Answer 9

The higher the ARR, the more profitable the investment.

Question 10

How is NPV (net present value) calculated?

Answer 10

Each year’s net cash flow is multiplied by the relevant discount factor.

Question 11

What does a high NPV figure show?

Answer 11

Higher NPV shows a more profitable investment.

Question 12

What are the strengths of payback periods as an investment appraisal method?

Answer 12

Easy to calculate and understand.
More accurate as it ignores longer-term forecasts which may be less accurate.
Considers timing of cash flows.
Useful for businesses with weak cash flow.

Question 13

What are the limitations of payback periods as an investment appraisal method?

Answer 13

Says nothing about profitability.
Ignores what happens after payback is achieved.
May encourage a short-termist attitude.

Question 14

What are the strengths of ARR as an investment appraisal method?

Answer 14

Clear focus on profitability.
Considers cash flows over the project’s lifetime.
Easy to compare with other measures of return expressed in % such as interest rates.

Question 15

What are the weakness of ARR as an investment appraisal method?

Answer 15

Ignores timing of cash flows.
Values far-distant inflows as much as more immediate inflows, which are ‘worth’ more.
Including forecast data from far in the future may reduce reliability of forecasts and results.

Question 16

What are the strengths of NPV as an investment appraisal method?

Answer 16

Takes the opportunity cost of money into account.
One calculation considering both amount and timing of cash flows to indicate profitability.

Question 17

What are the weakness of NPV as an investment appraisal method?

Answer 17

Complex to calculate and communicate.
Meaning often misunderstood.
Different projects only comparable if the initial outlay is the same.

Question 18

What do decision tree branches show?

Answer 18

A decision to be made, mainly an investment (square).
Chance events beyond the firm’s control, mainly whether an investment is a success (circle).

Question 19

How do you construct a decision tree?

Answer 19

Start with a square on the left.
Run a branch to a circle with the cost on each line.
Run a branch from the circles to show each possible outcome with the probability next to it.
Add decisions and chance events as required
When a branch is done, note the expected return at the end.

Question 20

How do you interpret a decision tree?

Answer 20

From right to left multiply each expected return by the probability of each possible outcome.
Once a square is encountered compare the expected values of each decision option. The business will choose the higher one.
Cross through the other ones to show that these choices should not be taken.

Question 21

What are the benefits of using decision trees?

Answer 21

Allows for uncertainty.
Managers forced to consider all options.
Problems set out clearly, encouraging a logical approach.
Quantification of problems encouraged by drawing of the tree and subsequent calculations.

Question 22

What are the drawbacks of decision trees?

Answer 22

Gathering he data required is hard, and likely to involve guesswork.
New problems mean previous occurrences cannot be used to base estimated probabilities and outcomes on, reducing the reliability of the data still further.
Element of bias introduced when estimating probabilities and outcomes.
Can lead to a failure to consider qualitative aspect of decisions.

Question 23

What is critical path analysis?

Answer 23

A technique used in planning the most time-efficient way to complete complex tasks involving constructing a network diagram to represent all of the tasks involved the projects completion.

Question 24

What three things does a critical path analysis diagram show?

Answer 24

The order, estimated length of time, and earliest date for each of the tasks.

Question 25

What are the two key component of a critical path analysis diagram?

Answer 25

Lines representing activities as part of an overall project.
Nodes placed at the start and end of activities.

Question 26

What are the five rules for drawing critical path analysis diagrams?

Answer 26

Networks must start and end on a single node.
Lines cannot cross.
A node should not be drawn at the end of an activity until you are sure which activity follows.
All lines must represent an activity.
Large nodes should be drawn while lines should be drawn short.

Question 27

Where is the EST shown on a critical path analysis diagram?

Answer 27

Top right-hand corner of each node. Starting at zero at the first node.

Question 28

Where is the LFT shown on a critical path analysis diagram?

Answer 28

Bottom right-hand corner of each node.

Question 29

How is the LFT calculated?

Answer 29

From right to left, deduct the duration of the following activity from the following activity’s LFT.

Question 30

What do ESTs show?

Answer 30

Earliest Start Time
The earliest date resources that are specially required for an activity may be needed, preventing money being wasted in them before they are needed.
The earliest completion date for the whole project.

Question 31

What do LFTs show?

Answer 31

Latest Finish Time
Deadlines for each activity.
Float time (if any).
Critical path of the project.

Question 32

How is float time calculated?

Answer 32

Float time = LFT - duration of the activity - EST

Question 33

What are the benefits of using critical path analysis?

Answer 33

Careful planning to work out each activity involved, duration, and what activities must be completed before another can begin, forcing a thorough planning process.
Identifies activities that can be completed simultaneously, shortening overall duration.
Resources needed can be delivered or hired JIT.
Network diagram shows possible ways of dealing with unforeseen delays and getting back on track.

Question 34

What are the limitations of using critical path analysis?

Answer 34

Network diagram can lull managers into a false sense of security.
Diagrams for really complex projects may become unmanageably large.
Not drawing activity lines to scale could devalue the diagram’s visual use.