Paper 2- Theme 3.3 Decision Making Techniques Flashcards
Define investment appraisal
the process of using quantitative data to asses the financial value of possible future investments
define payback
the amount of time it takes for an investment’s earnings to recoup the original cost of it.
payback month is calculated by
income needed
next year income ÷ 12 months
positives and negatives of payback
PROS
- quick and easy
- sole focus on breaking even
- ignores long term forecasts which may be less accurate
CONS
- doesn’t consider profitability
- ignores cash flow after payback period
- may encourage short-termism
- assumes receivables are steady throughout year (no idea of the timing of these)
define average rate of return
method used to calculate the net average return per year as a % of the initial investment cost
formula for ARR
average annual income
————————————- x 100
investment initial cost
strengths and weaknesses of ARR
PROS
- can compare with changing interest rates (see if saving is more beneficial)
- incorporates profitability and cash flow after full recoup of investment
- easily compare with other investments to reduce opportunity cost
CONS
- long term forecast more vulnerable to external changes
- assume firms only pursuing profit objectives
- ignores the timing of cashflows
- ignores time value of money (inflation)
define net present value
calculates the value of potential earnings in the future, in the present
define discounted cash flow
process of adjusting value of earnings in the future to its value in the present
formula for net present value
income x discount factor
what does the discount factor represent
what the interest rate is expected to be
positives and weaknesses of net present value
•PROS
- can see if any project is worth or if the opportunity cost of saving money in bank is more beneficial
- considers timing and amount of cashflows
- can cover different scenarios (interest rates at different levels)
•CONS
- complex to calculate & can’t compare projects with different initial cost
- assume discount factor will stay the same (unlikely interest rates will stay same)
- final value depends heavily on forecasted discount factor
factors affecting investment decisions (less common)
- corporate objectives (short term or long term)
- accuracy of data the forecast is based on and those interpreting forecasts
- social responsibilities (CSR, recycling or social schemes may have low ARR but still be done to gain publicity)
• wealth in company finance (e.g. gearing, liquidity)
- whether they can afford risk and uncertainty
define quantitative sales forecasting
using numerical information of historical data and trends to predict future sales revenue
define time series analysis
examples of TSA
method that allows businesses to predict future levels of sales through identifying trends in past sequences of data forecasting it into the future
e.g. extrapolation, three period moving averages, four quarter moving averages
Define extrapolation
method where you predict future levels of sales through analysing trends in past data and projecting this into the future
Positives and negatives of extrapolation
POSITIVES
- easy to implement
- accurate as based off up your own past sales
- quantitative target for sales
NEGATIVES
- doesn’t account for change in trends or demand
- ——-> disregards product life cycle
- assumes business will continue as they did in past
- assumes management can successfully review past data and forecast accurately
- not useful for dynamic markets
Define Moving average
statistical calculation of an underlying trend in data
Positives of using moving averages
- useful for analysing and understanding erratic or seasonal data
- —-> smooths out peaks and troughs in seasonal demand and so can see true sales figures
- identify growth trends and how they may continue in the future
- —> allow for efficient planning and allocation of resources
Define correlation
statistical technique used to establish the strength of the relationship between two variables
- usually displayed in a scatter graph
- use a line of best fit to determine the correlation of data (e.g. sales revenue against advertising costs)
uses of quantitative sales forecasting
- reduce risk of decision making
- more accurate than qualitative due to objectivity
- —–> reduces over optimism from enthusiastic employees that may inflate sales
- use to deduce budgets and cashflow forecast
- hard data showing historical growth you can attract new investors
- low cost, as only need your own past data, dont need to collect new data
drawbacks of forecasting sales through quantitative
- ignore qualitative factors (e.g. changes in tastes, fashion)
- doesn’t account for external factors PESTLE
- unreliable results if there are significant fluctuations in historical data
- —-> depends on ability of management to not forecast over optimistically
- unlikely past trends will continue in a competitive business environment
- —> competitors will act, and this is hard to predict
- —-> natural product life cycle
