3.3 - Decision Making Techniques Flashcards
(34 cards)
What is meant by extrapolation?
- The simplest way to predict future sales by assuming they will be just like the past.
- the sales for each month are added to a graph and the line is simply extended to predict future sales
What are the benefits of extrapolation?
- simple method of forecasting
- quick and cheap
- not much data required
What are the drawbacks of extrapolation?
- unreliable - if there are significant fluctuations in historical data
- assumes past trends will continue into the future - unlikely in many competitive business environments
- ignores qualitative factors e.g. changes in tastes
What is correlation?
similar to extrapolation but requires the use of a scatter graph in which a line of best fit
What are the benefits of correlation
- numerical so easy to interpret and easy to analyse for example graphs can be made
- data can be objectively interpreted and bias is often not an issue
What are the drawbacks of correlation?
- may lack detail
- correlation do not show cause and affect so may be hard to determine this
What is a loose correlation?
- in some cases the relationship between two variables will be negative or loosely linked.
- if this is the case, firms may wish to stop investing in ineffective projects in the hopes of boosting sales.
What is NPV?
- NPV method uses an important concept in investment appraisal - discounted cash flows
- recognises there in a change in value of money overtime
What is payback period?
The amount of time it takes to cover the costs of an investment
What is the formula for payback period?
Amount needed / net cash flow in year
NOTE:
- x12 answer in months
- x52 answer in weeks
What is ARR?
How much the business will make back off an investment
What is the formula for ARR?
ARR = average net profit per annum / initial investment (x 100)
What are the benefits of NPV?
- gives an accurate picture of an investments value
- Includes all projected inflows and outflows giving a comprehensive evaluation of the project
- helps businesses choose between competing projects by comparing their NPVs
What are the drawbacks of NPV?
- relies on estimates which can be inaccurate and affects the reliability of the result
- if the discount rate is too high or too low it can distort the NPV calculation
- doesn’t account for qualitative factors e.g. employee morale, customer impact etc
What are he benefits of payback period?
- simple and easy to calculate and understand
- helpful for businesses that need to recover their investment quickly due to tight cash flow
- projects with quicker paybacks are usually seen as less risky
What are the drawbacks of payback period?
- does not consider total profitability of a project, only how quickly the cost is recovered
- treated all cash inflow equally, regardless of when they occur
- encourages businesses to favour quick returns over long-term gains
What are the benefits of ARR?
- express return as a percentage, making it easy to compare with other options or interest rates
- considers the entire life of the project and all profits
- helps decide which project offers a better return on investment
What are the drawbacks of ARR?
- treats profit in year 1 the same as in year 5, which isn’t realistic
- profits are estimates and can be inaccurate
- project that generates profit slowly may seem just as good as one that pays off quickly.
What is a decision tree?
A diagram used to show possible outcomes, costs and probabilities or different business decisions to help chose the best option
What does a square represent in a decision tree?
A decision node - where a choice must be made between options
What does a circle represent in a decision tree?
A chance node - where outcomes depend depends on probability
What is the meaning of probability in a decision tree?
The likelihood of each possible outcome occurring (must add up to 1)
What is the expected value in a decision tree?
The weighted average of all possible outcomes for a course of action
How do you calculate expected value?
Multiply each outcome by its probability and add the results
