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DECISIONmaker

Business decisions should identify and consider all available alternatives. Generally, the more strategic a decision, the more complex it is. There can be many variables that need to be considered, and some of them have a high degree of uncertainty. For example, what if sales are lower or higher than expected? What if expenses are higher or lower? What if the price we can charge is lower or higher? How would that impact the decision?

To assist in making these types of strategic decisions, McFadden Consulting developed a proprietary model that combines a cash flow analysis, with sensitivity and probability analysis to provide a powerful quantitative strategic decision making tool. We call this model DECISIONmaker.

Essentially, DECISIONmaker incorporates and quantifies the impact of various uncertainties or "what-ifs" into a strategic decision, by combining a cash flow analysis, with sensitivity and probability analysis. Each of the three components is discussed below.

Cash Flow Component.  The cornerstone of DECISIONmaker is the cash flow component, which can be modified to utilize a number of different decision criteria, including:

  • internal rate of return
  • net present value
  • profitability index
  • accounting payback period
  • value of an asset
  • unit sales price or rate
  • cash flow requirements.

An illustration of the cash flow component is shown below.  The cash flow component calculates the financial implications of an alternative on the selected decision criterion, in this case net present value.  The cash flow is developed utilizing the implications and assumptions for each variable that are developed in the strategic planning process.  All the variables affecting an alternative are quantified.  For example, the level of revenues based on the assumption regarding sales units and prices are calculated for each year of the analysis.  Assumptions pertaining to operating expenses are also considered, including salaries, advertising and marketing expenditures, cost of goods, depreciation, and any other expenses.  All are based on the assumptions developed in the strategic planning process.

Sensitivity Component.  While the cash flow component is the cornerstone of the model, it is the sensitivity and probability components that combine to make DECISIONmaker a powerful decision-making tool.  For most variables affecting the cash flow there is a degree of uncertainty.  For example, sales could be higher or lower than expected.  For each such uncertainty, optimistic and pessimistic and most likely cases are determined.

In the sensitivity component, each of the uncertain variables is measured for its sensitivity against the decision criteria.  In other words, the cash flow component is executed based on the most likely case for each variable.  The cash flow component is then run again, with one uncertainty set at the optimistic or pessimistic case.  This practice isolates and quantifies the uncertainty by holding all other variables constant.  The cash flow model is then run again for each uncertainty.  The decision criterion is then compared to the result of the case in which all variables were set to the most likely case.  An example of the result of the sensitivity analysis is shown below.

The horizontal line in the middle of the graph represents net present value when all variables are set at the most likely case.  In this example, the net present value amounts to $36.665 million and is noted in the middle of the first variable, labeled Residential.  Assuming all other variables, i.e., Commercial, Industrial, Salaries, Marketing, Other, GasDisTran, and Financing are held constant and only Residential is allowed to vary, the net present value becomes $147.413 million in the optimistic case.  It is a negative $2.926 million, if the revenues are based on the pessimistic case.  The sensitivity component of the model calculates the net present value for each of the uncertainties, for the most likely, pessimistic and optimistic cases.  In this instance, there are seventeen different model runs.

Probability Component.  The probability component calculates the likelihood of the occurrence of each case.  In developing the most likely, optimistic, and pessimistic cases for each variable, a probability is assigned to each.  The most sensitive variables are utilized in the probability analysis.  The model is currently configured to consider five variables for the probability analysis, which translates into 243 different alternative cases.  In the vast majority of decisions, five variables are more than sufficient.  The probability component calculates and plots the outcome of the 243 different cases on a chart as illustrated below.

The net present value is identified on the x-axis and the probability is identified on the y-axis.  This exhibit indicates there is between an 80% and 90% probability that the net present value will be zero.  There is an almost 40% probability that the net present value is $50 million, and there is a 10% probability the net present value is $150 million.  The worst case suggests the net present value is approximately negative $25 million and the best case indicates the net present value is approximately $190 million.

In making strategic decisions, quantifying the financial impacts of various alternatives is critical. Without it, a decision would be made on qualitative information only. In such instances, the impact of successfully implementing the chosen alternative would be unknown. Furthermore, without knowing the financial impact, it is possible an alternative that is detrimental to an organization could be implemented. DECISIONmaker is a powerful tool that helps quantify the financial impacts and improves the decision making process.

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