In order to succeed in today's competitive era, it has become necessary for the managers to ensure that the organisation has a sound decision-making process. The decisions taken by the organisations may relate to the development of products and services, incentives to hire and retain talented employees, marketing strategies for attracting customers, or strategies to ensure growth and success in the market (Shapira, 2002).
However, for all the decisions that are to be taken by the managers, it is essential that it is an informed decision, that is, there is a sufficient availability of the information, on the basis of which the decision is taken (Nestor-Harper, 2017). There are various tools and techniques available which allows the managers to compare different alternatives and find the one which has the best outcome.
These tools and techniques may include sensitivity analysis, break-even analysis in case of development of new products, scenario analysis, or the application of simulation techniques. In this respect, the following discussion attempts to define the concept of decision-making in an organisation. It is aimed at explaining the link between various capital budgeting techniques, the analytical tools and the way in which they contribute to the overall corporate decision-making.
The main assumption in the decision-making process of an organisation is the presence of quality information. Majority of the decisions taken in an organisation are likely to affect long-term sustainability of the organisation, especially the decisions concerning huge investments (Kono and Barnes, 2010). For taking the investment decisions, it is essential that different financial alternatives are thoroughly analysed using different techniques.
The financial tools ensure that the decision maker is aware of the decision-making process and has appropriate information which forms the framework for analysing different alternatives. It is not necessary that the decision-making process followed in is same for all the organisations; however, in general, it refers to a step by step process of choosing the best alternative after gathering relevant information and analysing the available options for addressing a problem (Nutt and Wilson,2010; Ingram, 2017).
In the context of investment decisions, the main tool and technique used for gathering information and analysing multiple options are the capital budgeting techniques. It is a step by step process which is used to determine the rate of return that the project or the alternative is likely to earn if the investment is made (Dayananda, 2002). These techniques are helpful for the managers to determine which projects are more profitable and the duration within which value of the initial investment would be realised.
Capital budgeting technique is considered as a useful tool in the decision-making process as it creates measurability and accountability. This is due to the reason that any investment decision taken without considering the return and risks associated with the project may serve as a reason for the downfall of an organisation. It is one of the techniques that is effective in measuring the efficiency of investment decisions and allow the managers to invest company’s money in the profitable alternatives (Baker and English, 2011).
With the help of capital budgeting techniques, managers are likely to have an in-depth knowledge about the company’s prospective alternatives. It can help the managers in developing long-term strategic plans for the company and seeking out the new profitable investment options. It even enables the managers to forecast future estimated cash flows of the company in case of different investment projects, which is regarded as the main source for creating value for the company in long run.
Unlike other decisions of the business which usually includes a single aspect, capital budgeting techniques help the decision maker to take decisions related to company’s finance and its investment (Peterson and Fabozzi, 2004). The combination of sound finance and investment decisions can help the company not only in making profits but would also assist in attaining a competitive edge over its competitors in the market.
The sensitivity analysis, also known as what-if analysis is a technique widely used by the managers to gather relevant information for taking decisions. This technique is mostly used for an in-depth study of the alternatives that are present for taking investment decisions. Under this technique, with the assumptions being constant, two variables are studied, namely dependent variable and independent variable.
The independent variable is used to determine the way in which the dependent variable will react, that is, the changes in the independent variable is measured on the dependent variable, under a set of given assumptions. With the help of this technique, future outcomes of the decision can be predicted through dependent and independent variable. This technique is useful where the managers are of opinion that there is a possibility that the assumptions made can turn out to be unreliable.
The manager is given an opportunity to make changes in the assumptions and other estimates, and determine the effect that it may have on the finances of the project that is to be undertaken. It actually serves as a basis for preparing the managers for contingencies that may arise during the course of a project and the possible losses that it may cause due to such contingencies.
In respect of the techniques used for capital budgeting, it serves as a tool for calculating the extent of change in assumptions on the benefits of the project. This signifies that this tool helps in measuring the impact on the net benefits of the project in the quantitative terms (Koening, 2017). The impact of changes in assumptions and estimates, especially in the form of cost, risk and return is calculated on the internal rate of return and the net present value of the projects.
This analysis helps in finding out the extent to which the net present value of the project is sensitive to the variables that are used for calculation purpose. Moreover, this would also help the decision makers in identifying the reasons for the failure of project. Adoption of this analytical tool can serve a twin purpose in the decision-making process of a company.
The first purpose is that with the help of changing the assumptions and estimates in a project, the managers are likely to find out the trend of changes in the outcomes of the project. Secondly, it would help in determining the role that the input variables play in the economic worth of the project (Borgonovo, 2017). If the input variables are significant or key determinants of the project, the manager has to critically analyse other factors also while making the investment and finance decisions.
The scenario analysis is an advanced form of sensitivity analysis as it allows the managers to make changes in multiple assumptions at the same time. The decision makers use this analytical tool for measuring the potential variability that exists in the outcomes of a project. Unlike the earlier analytical tool which only allows changes in a single variable, this method enables the managers to make changes in multiple estimates or assumptions.
There can be multiple independent variables in the scenario analysis and the impact of all these variables is measured on the outcome of project (Munier, 2011). On the basis of multiple scenarios constructed by managers by altering the estimates, a range of net present value is determined within which the actual outcome of the project would lie.
Apart from establishing a base scenario, two more scenarios are established to identify the worst and best net present values of the project, which are termed as worst case scenario and best case scenario respectively. The best and the worst case depict the upper and lower range of the possible outcomes and it is estimated that the actual outcome of the project would fall in this determined range.
The best case scenario would have higher profits, low costs, extended product lifecycle, better salvage value of the assets and other favourable conditions (Damodaran, 2008). On the other hand, the worst case scenario would show opposite conditions in terms of sales, profits, costs, prices and salvage value of assets. The main aim of the scenario analysis is to identify the joint impact of multiple variables on the outcome of project.
Break-even analysis is an effective tool for taking decisions in investment projects which require the development of new products and services. With the help of this analytical tool, the managers can determine the break-even points, such as the quantity that is to be manufactured and the price at which it should be sold (Vance, 2002). This analysis helps in specifying the requirements that are necessary for the company to ensure that it does not go into losses with the investment decision.
This tool focuses on identifying the level which is required to be attained by the company to ensure a no profit, no loss situation. It specifies the minimum quantity that is required so that the project does not incur any losses and where the costs incurred in the project is equivalent to the benefits generated by such investment. In addition to the break-even points, this tool is also effective for studying the nature of different costs that are associated with a project, namely- variable costs, fixed costs and total costs (Cafferky, 2010).
However, for taking investment and finance decisions, the managers are required to toughly investigate the entire project and just not take decisions based on this tool. This is due to the reason that in certain situations it does not provide the necessary information such as the extent to which the results of the project are good or bad or the probability of the outcomes.
The simulation techniques for analysing the alternatives are considered to be an appropriate technique for decision-making. Unlike other analytical tools discussed above, this technique has the capability of indicating probability of the occurrence of outcomes. With the application of computer software, the managers can make continuous changes in different variables and estimates and develop a probability distribution which can indicate the probability of occurrence of certain outcomes (Tam, Tong and Zhang, 2007).
This technique enables the manager to determine the probability of the net present value of the projects with the probability of the project outcomes and the relationship that exists between them. In order to examine the outcomes that are risky in nature, this technique makes use of probability solutions and random numbers which are predetermined. For every input variable, simulators are run once the statistical distribution for each variable is estimated (Rosenthal and Pijnenburg, 2012). The purpose of running simulators is to identify the pattern in which the variables of the project affect its outcome.
On the completion of this process, the decision makers have the overview of the estimated outcomes of the project and the probability with which this outcome would be achieved. It helps in developing different scenarios of risk-return trade-off, unlike the other analytical tools which provide single point estimates of risk-return trade-offs.
Every organisation has its own decision-making process and it is necessary for the decision makers to understand this process. The quality of the decisions helps in directing the organisation towards long-term success; for which it is necessary that the managers have the required information for making an informed decision. It is the responsibility of the decision maker to use different analytical tools so that all the alternatives are properly analysed, keeping in consideration the positive and negative aspects of each alternative.
It is concluded that investment and finance decisions are one of the critical decisions which have a direct impact on sustainability of the business. The capital budgeting techniques allow the managers to analyse the risk associated with each project and the rate of return that it earns. Even for making the decision for the best investment, the managers can make use of the analytical tools, such as scenario analysis, break-even analysis, sensitivity analysis and simulation techniques.
The sensitivity analysis allows the managers to make changes in the input variable and determine its impact on the project outcome. Similarly, the scenario analysis allows the decision makers to establish a range of best and worst case scenarios within which the actual outcome of the project would lie.
This outcome is measured by making changes in multiple assumptions and input variables. The break-even analysis helps the managers in identifying the optimum quantity that is required for avoiding losses in case of new projects. However, the simulation techniques have an edge over other tools as it also depicts the probability of occurrences of the outcomes.
Baker, H. K. and English, P. 2011. Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. New Jersey: John Wiley & Sons.
Borgonovo, E. 2017. Sensitivity Analysis: An Introduction for the Management Scientist. Berlin: Springer.
Cafferky, M. 2010. Breakeven Analysis: The Definitive Guide to Cost-Volume-Profit Analysis. New York: Business Expert Press.
Damodaran, A. 2008. Strategic Risk Taking: A Framework for Risk Management. New Jersey: Pearson Prentice Hall.
Dayananda, D. 2002. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press.
Ingram, D. 2017. What Are the Steps in the Decision-Making Process of a Manager? [Online]. Available at: https://smallbusiness.chron.com/steps-decisionmaking-process-manager-10601.html [Accessed on: 18 September 2017].
Koening, E. 2017. Sensitivity Analysis for Capital Budgeting. [Online]. Available at: https://smallbusiness.chron.com/sensitivity-analysis-capital-budgeting-10153.html [Accessed on: 18 September 2017].
Kono, P.M. and Barnes, B. 2010. The role of finance in the strategic-planning and decision-making process. Graziadio Business Report 13(1), pp. 1-5.
Munier, N. 2011. A Strategy for Using Multicriteria Analysis in Decision-Making: A Guide for Simple and Complex Environmental Projects. Berlin: Springer.
Nestor-Harper, M. 2017. Decision Making Processes in Organizations. [Online]. Available at: https://smallbusiness.chron.com/decision-making-processes-organizations-26291.html [Accessed on: 18 September 2017].
Nutt, P.C. and Wilson, D.C. 2010. Handbook of Decision Making. New Jersey: John Wiley & Sons.
Peterson, P.P. and Fabozzi, F.J. 2004. Capital Budgeting: Theory and Practice. New Jersey: John Wiley & Sons.
Rosenthal, U. and Pijnenburg, B. 2012. Crisis Management and Decision Making: Simulation Oriented Scenarios. Berlin: Springer Science & Business Media.
Shapira, Z. 2002. Organizational Decision Making. Cambridge: Cambridge University Press.
Tam, C.M., Tong, T.K.L. and Zhang, H. 2007. Decision Making and Operations Research Techniques for Construction Management. Kowloon: City University of HK Press.
Vance, D.E. 2002. Financial Analysis and Decision Making. New York: McGraw Hill Professional.
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