Paper 2- Theme 3.3 Decision Making Techniques

Question 1

Define investment appraisal

Answer 1

the process of using quantitative data to asses the financial value of possible future investments

Question 2

define payback

Answer 2

the amount of time it takes for an investment’s earnings to recoup the original cost of it.

Question 3

payback month is calculated by

Answer 3

income needed

next year income ÷ 12 months

Question 4

positives and negatives of payback

Answer 4

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)

Question 5

define average rate of return

Answer 5

method used to calculate the net average return per year as a % of the initial investment cost

Question 6

formula for ARR

Answer 6

average annual income
————————————- x 100
investment initial cost

Question 7

strengths and weaknesses of ARR

Answer 7

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)

Question 8

define net present value

Answer 8

calculates the value of potential earnings in the future, in the present

Question 9

define discounted cash flow

Answer 9

process of adjusting value of earnings in the future to its value in the present

Question 10

formula for net present value

Answer 10

income x discount factor

Question 11

what does the discount factor represent

Answer 11

what the interest rate is expected to be

Question 12

positives and weaknesses of net present value

Answer 12

•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

Question 13

factors affecting investment decisions (less common)

Answer 13

• 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

Question 14

define quantitative sales forecasting

Answer 14

using numerical information of historical data and trends to predict future sales revenue

Question 15

define time series analysis

examples of TSA

Answer 15

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

Question 16

Define extrapolation

Answer 16

method where you predict future levels of sales through analysing trends in past data and projecting this into the future

Question 17

Positives and negatives of extrapolation

Answer 17

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

Question 18

Define Moving average

Answer 18

statistical calculation of an underlying trend in data

Question 19

Positives of using moving averages

Answer 19

• 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

Question 20

Define correlation

Answer 20

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)

Question 21

uses of quantitative sales forecasting

Answer 21

• 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

Question 22

drawbacks of forecasting sales through quantitative

Answer 22

• 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