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 DECISION
maker 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.
While the cash flow component is the cornerstone of the model,
it is the sensitivity and probability components that combine to
maker 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.
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
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