15: Financial Mathematics Used In Decision Making Flashcards
To be relevant, the resulting cash flow must meet what three tests?
- Incremental and avoidable cash flows - incremental = incurred only if proposal goes ahead. If cost otherwise avoidable, then should be ignored e.g. rent= irrelevant
- Cash flows not already been incurred (sunk costs - alrdy incurred) = irrelevant e.g. R&D costs to date
- Revenue or cost must actually impact a cash flow - if not then it’s irrelevant e.g. depreciation
Opportunity cost
Must include lost revenue and associated variable costs (I.e. contribution) that will not be incurred as a result of pursuing the proposal. (Value of next best alternative foregone)
Break even formula
Revenue- VC - FC = 0
Contribution per unit
Revenue per unit - Total variable costs per unit
Break even output formula
Total FC / Contribution per unit
Margin of safety formula
Planned sales - Breakeven sales / Planned sales x100%
Output to hit a target profit
(Total fixed costs + target profit ) / contribution per unit
What are issues with break-even analysis
- assumes revenue and variable costs change proportionally with volume
- Some fixed costs are stepped fixed costs - additional cost incurred once certain threshold is reached
- For Multi product businesses, hard to identify which costs are attributable to what products being manufactured
What is sensitivity analysis
Involves changing value of one variable in order to test its impact on the final result
Allows an org to consider range of possible outcomes by asking what if? Questions
Formula for probability of achieving desired result
Number of ways of achieving desired result / Total number of possible outcomes
What is expected values
Sum of probability of the outcome occurring x acc outcome
Limitations of expected values
- Probabilities used when calculating ev’s are likely to be estimates; unreliable/innacurate
- do not consider attitudes to risk
- does not consider time value of money (inflation)
How do decision trees work - Right to left
Work out cost based on probabilities and units n then add the two calculations together to find the budget used e.g. 79200 (6.90 x 12000 units)
Vs 99000(6.60 x 150000 units)
79200 x 0.8 (80% chance it will sell 12000 units) + 990000 x0.2 (20% chance) = £83160
Decision Trees left to right
Multiply each tree branch and add them up
Limitations of decision trees
- estimates (subjective/unreliable)
- only consider financial outcomes
What is Trend analysis and its uses
Uncovers patterns in a company’s data in order to predict future trends and support strategic decisions. Uses:
- Plotting monthly revenue and cost info
- Forecasting by extrapolating the trend line, future values could be estimated.
Coefficient of variation
S.D/ Mean x100
What is the percentage of s.d from mean normal distribution
34.1% either side
