15: Financial Mathematics Used In Decision Making

Question 1

To be relevant, the resulting cash flow must meet what three tests?

Answer 1

1. Incremental and avoidable cash flows - incremental = incurred only if proposal goes ahead. If cost otherwise avoidable, then should be ignored e.g. rent= irrelevant
2. Cash flows not already been incurred (sunk costs - alrdy incurred) = irrelevant e.g. R&D costs to date
3. Revenue or cost must actually impact a cash flow - if not then it’s irrelevant e.g. depreciation

Question 2

Opportunity cost

Answer 2

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)

Question 3

Break even formula

Answer 3

Revenue- VC - FC = 0

Question 4

Contribution per unit

Answer 4

Revenue per unit - Total variable costs per unit

Question 5

Break even output formula

Answer 5

Total FC / Contribution per unit

Question 6

Margin of safety formula

Answer 6

Planned sales - Breakeven sales / Planned sales x100%

Question 7

Output to hit a target profit

Answer 7

(Total fixed costs + target profit ) / contribution per unit

Question 8

What are issues with break-even analysis

Answer 8

1. assumes revenue and variable costs change proportionally with volume
2. Some fixed costs are stepped fixed costs - additional cost incurred once certain threshold is reached
3. For Multi product businesses, hard to identify which costs are attributable to what products being manufactured

Question 9

What is sensitivity analysis

Answer 9

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

Question 10

Formula for probability of achieving desired result

Answer 10

Number of ways of achieving desired result / Total number of possible outcomes