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Analytics for Managerial Decision
Making
Budgeting and Decision Making
Larry M
...
Skousen

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Larry M
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2

Analytics for Managerial Decision Making: Budgeting and Decision Making
1st edition
© 2010 Larry M
...
Skousen &
bookboon
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All material in this publication is copyrighted, and the exclusive property
of Larry M
...

ISBN 978-87-7681-577-6

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1

Sunk Costs VS
...
2

A Basic Illustration of Relevant Cost/Benefit Analysis

9

1
...
1

Outsourcing

11

2
...
3

Capacity Considerations in Outsourcing

14

2
...
5

Qualitative Issues in Outsourcing

15

2
...
7

Capacity Constraints and the Impact on Special Order Pricing

17

2
...
9

The 80/20 Concept

19

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1

Management Stewardship

22

3
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1

Compound Interest

23

4
...
3

Future Value of an Annuity Due

25

4
...
5

Present Value

27

4
...
7

Present Value of an Ordinary Annuity

28

4
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9

Challenge Your Thinking

29

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Analytics for Managerial Decision Making

Contents

5

Evaluation of Long-Term Projects

30

5
...
2

Impact of Changes in Interest Rates

31

5
...
4

Accounting Rate of Return

33

5
...
6

Payback Method

35

5
...

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• A general framework for making rational business decisions
...

• Compound interest and present value
...


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You may have taken
an exam and regretted some stupid mistake
...
Or,
maybe you did not really know the material; your judgment about how much to study left you doomed
from the start!
Business people will experience similar feelings
...
Perhaps parking lot lights
were unnecessarily left on during daylight hours
...
Earlier chapters discussed
numerous methods for monitoring and controlling against waste
...
For a public company that is valued based on a multiple of reported income,
a dollar wasted can translate into many times that in lost market value
...
There is really no
excuse for stepping into a business plan when it has little or no chance for success
...
Regret is perhaps the only lasting outcome
...
These techniques won’t eliminate execution errors, but they will help you avoid
many of the judgment errors that are all too common among failing businesses
...
1

Sunk Costs VS
...
There is an old adage that cautions against throwing good money
after bad
...
A sunk cost
relates to the historical amount that has already been expended on a project or object
...
Would you now
attempt to buy a matching pair of pants because you had invested so much in the shirt? Obviously not
...

In business decision making, sunk costs should be ignored
...
Relevant items are those where future costs and revenues are expected to differ for the alternative
decisions under consideration
...

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2

Cost Characteristics and Decision-Making Ramifications

A Basic Illustration of Relevant Cost/Benefit Analysis

During a recent ice storm, Dillaway Company’s delivery truck was involved in a traffic accident
...
An insurance company has provided Dillaway
$30,000 for the damages that were incurred
...
Dillaway
has found an undamaged, but otherwise identical, used truck for sale on the internet for $32,000 what
decision is in order?
The truck’s original cost of $60,000 is sunk, and irrelevant to the decision process
...
The financial statement “gain” that would be reported on a sale is
irrelevant
...
e
...
All that matters is to note that the truck can be repaired for $24,000,
or the truck can be sold for $10,000 and a similar one purchased for $32,000
...
it
seems clear that the better option is to sell the damaged truck and buy the one for sale on the internet
...
The same conclusion can be reached by a more comprehensive analysis of all costs and
benefits
...
This analysis also supports sale and replacement
because the income and cash flow impacts are $2,000 better than with the repair option:
ANALYSIS FOR SALE OF TRUCK

ANALYSIS FOR REPAIR OF TRUCK

Cost of damaged truck
Accumulated depreciation on damaged truck
Net book value of damaged truck
Less: Insurance recovery
Resulting reduced basis
Sales price of damaged truck
Less: Reduced basis (from above)
Gain on sale of truck

$ 32,000

Lifetime income effect:
Gain on sale of truck
Future depreciation
Net impact on income
Cash flow impacts:
Insurance recovery
Sales price of damaged truck
Purchase price of truck
Net impact on cash

$ 60,000
24,000
$ 36,000
30,000
$ 6,000
24,000
$ 30,000

Future depreciation (resulting basis)

$ 10,000
6,000
$ 4,000

Future depreciation (purchase price/new truck)

Cost of damaged truck
Accumulated depreciation on damaged truck
Net book value of damaged truck
Less: Insurance recovery
Resulting reduced basis
Plus: Money to repair truck
Resulting basis

$ 60,000
24,000
$ 36,000
30,000
$ 6,000

$ 30,000

Lifetime income effect:
Gain on sale of truck
Future depreciation
Net impact on income

$

4,000
(32,000)
$ (28,000)

Cash flow impacts:
Insurance recovery
Repair costs

$ 30,000
10,000
(32,000)
$ 8,000

Net impact on cash

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...
Although it is
more descriptive of the entirety of the two alternatives, it is unnecessarily confusing
...

In one sense, Dillaway was lucky
...
Many times, a favorable outcome cannot be identified
...
Nevertheless, decisions must be made
...


1
...
Suppose the local truck dealer
offered Dillaway a third option: A $27,000 trade-in allowance toward a new truck costing $80,000
...
This is obviously more costly than either
of the other two options
...
As a result, Dillaway must now
begin to consider other qualitative factors beyond those evident in the incremental cost analysis
...
Rarely are two (or more) options under consideration driven
only by quantifiable mathematics
...

Therefore, as you develop your awareness of the analytical techniques presented throughout this chapter,
please keep in mind that they are based on concrete textbook illustrations and logic
...
Do not assume that analytical methods can be
used to solve all business problems, but do not abandon them in favor of wild guess work!

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Classic
examples include whether to outsource or not, when to accept special orders, and whether to discontinue
a product or project
...
In general,
that approach requires identification of decision alternatives, logging relevant costs/benefits of each
choice, evaluating qualitative issues, and selecting the most desirable option based on judgmental
balancing of quantitative and qualitative factors
...
Analytics support decision making, but they do not supplant
judgment
...
1 Outsourcing
Companies must frequently choose between using outside vendors/suppliers or producing a good or
service internally
...
For instance, some companies
outsource data processing, tech support, payroll services, and similar operational aspects of running
a business
...
Further, some companies (e
...
, certain high
profile sporting apparel companies) have broad product lines, but actually produce no tangible goods
...
Outsourcing
has been around for decades, but it has received increased media/political attention with the increase in
global trade
...

As a result, companies must constantly assess the opportunities for improved results via outsourcing
...
com

11

Analytics for Managerial Decision Making

Business Decision Logic

The outsourcing decision process should include an analysis of all relevant costs and benefits
...
As usual, avoid
the temptation to consider sunk costs as part of the decision analysis
...
Unless the outsourcing option results in a complete elimination of a factory or facilities, the
fixed overhead is apt to continue whether the service/product is purchased or produced
...
On the other
hand, if some fixed factory overhead can be avoided by outsourcing, it should be taken into consideration
as a relevant item
...
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2

Business Decision Logic

Outsourcing Illustration

Pilot Corporation produces software for handheld global positioning systems
...
It is used by airline pilots, mariners, and others
...
The
annual budget for the tech support department is shown below
...
The utilities and maintenance are fixed, but would be avoided if the unit were shut down
...
Phone and computer
equipment is leased under a flat rate contract, but the agreement is cancelable without penalty
...

Direct labor
Utilities and maintenance
Building rent
Phone/computer leasing
Annual depreciation of furniture and fixtures

$ 315,360
40,000
120,000
60,000
100,000
$ 635,360

Pilot has been approached by Chandra Corporation, a leading provider of independent tech support
services
...
Pilot estimates that it generates about 50,000 support events per year
...
However, a correct analysis for Pilot focuses only on the relevant
items (following)
...
The cost of furniture and fixtures is a sunk cost (it is
not relevant to the decision)
...
Therefore, the quantitative analysis suggests that Pilot should continue to provide its
own tech support in the near future
...

Direct labor
Utilities and maintenance
Building rent
Phone/computer leasing
Annual depreciation of furniture and fixtures

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3

Business Decision Logic

Capacity Considerations in Outsourcing

Outsourcing analysis is made more complicated if a business is operating at capacity
...
In other
words, if a company continues to manufacture a product in lieu of outsourcing, it foregoes the chance to
produce the alternative product
...
Accountants (and economists and others) may use the term “opportunity cost” to describe the
cost of foregone opportunities
...


2
...
The kits include all of the parts necessary to easily construct metal barns of various shapes
and sizes
...
In an effort to free up capacity, Mueller contracted with Zhang Manufacturing of China to
produce all roof truss components to be included in the final kits
...

Mueller’s accounting department prepared the following analysis that was used as a basis for negotiating
the contract with Zhang:
Direct labor to produce trusses
Direct material to produce trusses
Variable factory overhead to produce trusses
Avoidable fixed factory overhead to produce trusses
*
Relevant costs to produce trusses
Contribution margin associated with 10% increase in kit production
Maximum amount to spend (including transportation) for purchased trusses

$ 3,800,000
4,000,000
2,000,000
1,000,000
$ 10,800,000
3,000,000
$ 13,800,000

Notice that the analysis reveals that Mueller will reduce costs by only $10,800,000 via outsourcing, but
can easily spend more than this on purchasing the same units
...

One must be very careful to fully capture the true cost of outsourcing
...

Likewise, if outsourcing results in employee layoffs, expect increases in unemployment taxes, potential
acceleration of pension costs, and other costs that should not be ignored in the quantitative analysis
...
Capital budgeting decisions are covered later in this chapter
...
com

14

Analytics for Managerial Decision Making

2
...

Outsourcing places quality control, production scheduling, and similar issues in the hands of a third
party
...
If goods are being moved internationally, goods may be subject to high
freight costs, customs fees, taxes, and other costs
...
Hopefully rare,
but not to be ignored are risks associated with relying on suppliers in politically unstable environments;
significant disruptions are not without precedent
...
Although global
trade is increasingly reliant on English, there are still many miscues brought about by a failure to have
full and complete communication
...
Examples include frustrations with call centers and tech support lines where language barriers
become apparent, and customer protest/rejection because of perceived unfair labor practices in certain
global regions
...


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6

Business Decision Logic

Special Orders

A business may receive a special order at a price that is significantly different from the normal pricing
scheme
...
In other words, it must be determined whether the special order sales price exceeds the variable
production and selling costs associated with the special order
...

The “cost” to produce a Rippin’ Rogue is $1
...
20 direct materials, $0
...
50 factory overhead
...
Lunker Lures
are sold to retailers across the country through an established network of manufacturers’ representatives
who are paid $0
...

Lunker Lures has been approached by Walleye Pro Fishing World to produce a special run of 1,000,000
units
...
Walleye Pro Fishing World’s offer is priced at $1
...
Lunker Lures
is obligated to pay its representatives half of the normal rep fee for such private label transactions
...
After all, the offer is priced below
the noted cost of production
...
20 × 1,000,000) by accepting the order
...
50 X 30%)
Manufacturing margin
Variable selling costs (50% of normal)
*
Contribution margin

$ 0
...
40
0
...
00
0
...
25
0
...
20

Note: Aggregate fixed costs will be the same whether the special order is
accepted or not
...


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7

Business Decision Logic

Capacity Constraints and the Impact on Special Order Pricing

A potential error in special order pricing is acceptance of special orders offering the highest contribution
margin per dollar of sales, while ignoring capacity constraints
...
20/$1
...
Suppose Bass Pro Fishing World also placed
a special order for a Bass Buzzer lure, and that special order afforded a 30% margin on a $1
...
At first glance, one would assume that the Bass Pro Fishing World would represent
the better choice
...
20) while the total contribution on the Buzzer
is $180,000 (600,000 × 30%)
...
This important distinction gives consideration to the fact that producing a
few units (with a high per-unit contribution margin) may be less profitable than producing many units
(with a low per-unit contribution margin)
...


2
...
Such decisions can have far reaching effects on the company, shareholder perceptions
about management, employees, and suppliers
...
So, what
analytical methods should be employed to support a final decision to pull the plug on a business unit?
Management should not merely conclude that any unit generating a net loss is to be eliminated! This is
an all too common error made by those who lack sufficient accounting knowledge to look beyond the
bottom line
...
Consider that some
fixed costs identified with a discontinued unit may continue and must be absorbed by other units
...
Instead, the appropriate
analysis is to compare company wide net income “with” and “without” the unit targeted for elimination
...
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17

Analytics for Managerial Decision Making

Business Decision Logic

Casa de Deportes is a mega sporting goods store occupying 80,000 square feet of space in a rented retail
center
...
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18

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Analytics for Managerial Decision Making

Business Decision Logic

Management is quite concerned about the Golf Department
...
Further, no one at Casa de Deportes, including the Golf Department manager,
believes this situation is apt to change anytime soon
...
In preparing the “without golf ” report,
it was learned that only 70% of the General and Administrative costs would be eliminated, rent and
depreciation would continue to be incurred, and utilities would be reduced by only half
...
The unavoidable costs from the golf department are assumed to be
shifted equally to the other departments (although other allocation methods could be used, the overall
conclusions would not change)
...
The reallocation of
unavoidable costs not only reduces overall profitability, but it also paints the Camping Department in
a precarious light
...
g
...
Another factor not
included above are the incremental costs from closing a department (e
...
, inventory write-offs, increased
unemployment compensation costs for laid off workers, etc
...


2
...
However, an in-depth evaluation
is likely to reveal that a significant portion of its success is centered around a narrow set of products,
customers, and services
...
For example,
a technology-based business may find that some of its lowest-volume customers consume the largest
amount of the tech support staff ’s time (due to customer inexperience with the product) while the large
volume customers require almost no assistance with the company’s product
...
com

19

Analytics for Managerial Decision Making

Business Decision Logic

It requires a great deal of business discipline to “abandon” a product, customer, or service, but such
decisions can actually contribute to business success
...
The basic concept of this 80/20 business process is to focus
on what is most important (the 20% of the items which account for 80% of the value) and to spend less
time and resources on the less important (the 80% of the items which account for 20% of the value)
...
The Company’s
700 operations utilize the 80/20 process in various aspects of its business
...

• Simplifying the customer base by focusing on the 80/20 customers and finding different
ways to serve the 20/80 customers
...

• Designing business processes and systems around the key 80/20 activities
...
These 80/20 efforts often result in restructuring projects that reduce costs and
improve margins
...
”
Some contend that this approach results in sacrificing long-term opportunities to enhance short-term
profitability
...
As a result, the 80/20 philosophy is not always the optimum strategy and good
business judgment should always be exercised in the decision-making process
...
com

20

Analytics for Managerial Decision Making

Capital Expenditure Decisions

3 Capital Expenditure Decisions
Much of the discussion has focused on decisions relating to near-term operations and activities
...

Such capital expenditure decisions relate to construction of new facilities, large outlays for vehicles and
machinery, embarking upon new product research and development, and similar items where the upfront
cost is huge and the payback period will span years to come
...
Thus, the final decision may involve consideration
of architectural, engineering, marketing, and numerous other variables
...
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In addition, capital expenditure decisions (also called capital budgeting)
are usually accompanied by a number of alternatives from which to choose
...
For instance, you
are currently investing time and money in your education; probably you could make more money in
the near-term by working more hours in a paying job and devoting less time to study – but you know
the long-term is better served by investing in your education
...

For example, should a new computer information system be installed? In the near-term the business
might appear more profitable by not buying a new system – but the long-run may be better served by
making the investment
...
1

Management Stewardship

Capital expenditure planning requires managers to effectively evaluate and rank alternatives
...
In addition, managers must understand the goals of business owners: What is to be optimized, shortrun or long-run performance goals? How much risk is to be undertaken in pursuit of an opportunity?
Managers naturally feel pressure to deliver in the near-term, for fear of not keeping their jobs in the
long-term
...
2

Logic Justification of Capital Decisions

Fortunately, a number of very helpful analytical tools are available to bring logical and rational decisionmaking processes to bear on capital expenditure decisions
...
A good manager is well advised to understand and utilize these tools
...
In addition, managers can use these tools to clearly
convey justification for making certain decisions, even if they appear to be illogical in the near-term
...
com

22

Analytics for Managerial Decision Making

Compound Interest and Present Valu

4 
Compound Interest and Present
Value
You have heard the expression that “time is money
...
The fundamental idea is that a dollar received today is worth
more than a dollar to be received in the future
...

In the context of capital budgeting, assume two alternative investments have the same upfront cost
...
Investment Beta returns $50 per
year for each of the next 10 years
...
Although the total cash returns are the same, the time value of money is better for Alpha
than Beta
...

Of course, very few capital expenditure choices are as clear cut as Alpha and Beta
...


4
...
“The most powerful force in the universe is compound interest
...
While
it is not clear that he actually held compound interest in such high regard, it is clear that understanding
the forces of compound interest is a powerful tool
...

In this context, consider that when you spend a dollar on a soft drink, you are actually foregoing 10¢
per year for the rest of your life (assuming a 10% interest rate)
...

Compound interest calculations can be used to compute the amount to which an investment will grow
in the future
...
If you invest $1 for one year, at 10% interest
per year, how much will you have at the end of the year? The answer, of course, is $1
...
This is calculated
by multiplying the $1 by 10% ($1 × 10% = $0
...
10 to the original dollar
...
10 is invested for another year at 10%, how much will you have? The answer is $1
...
That
is, $1
...
This process will continue, year after year
...
com

23

Analytics for Managerial Decision Making

Compound Interest and Present Valu

The annual interest each year is larger than the year before because of “compounding
...
This formula expresses
the basic mathematics of compound interest:
(1+i) n
Where “i” is the interest rate per period and “n” is the number of periods

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10 to the 25th power [(1
...
83
...
To experiment with the future value table, determine how much $1 would grow
to in 10 periods at 5% per period
...
63, and can be found by reference
to the value in the “5% column/10-period row
...
45 ($5,000 × 1
...
In using the tables, be sure to note that the
interest rate is the rate per period
...
It all depends on
how frequently interest is to be compounded
...
If the same investment
involved annual compounding, then you would refer to the 12% column and 2-period row
...
26973, while annual compounding returns only 1
...
2

Future Value of Annuities

Annuities are level streams of payments
...
Sometimes, one may be curious to learn how much a recurring stream of payments will grow
to after a number of periods
...
3

Future Value of an Annuity Due

An annuity due (also known as an annuity in advance) involves a level stream of payments, with the
payments being made at the beginning of each time period
...
If the annual interest rate is
10% per year, how much will you accumulate by the end of the 5-year period? The following graphic shows
how each of the five individual payments would grow, and the accumulated total would reach $33,578:

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...
The same
conclusion can be reached by reference to a FUTURE VALUE OF AN ANNUITY DUE TABLE
...
71561 (10% column/5-period row)
...
71561)
...
4

Future Value of an Ordinary Annuity

Sometimes an annuity will be based on “end of period” payments
...
The next graphic portrays a 5-year, 10%, ordinary annuity
involving level payments of $5,000 each
...
This means each payment will accumulate interest for
one less year, and the final payment will accumulate no interest! Be sure to note the striking difference
between the accumulated total under an annuity due versus and ordinary annuity ($33,578 vs
...

The moral is to save early and save often (and live long!) to take advantage of the power of compound
interest
...
Review the table found in the appendix to satisfy yourself about the $30,526 amount ($5,000 ×
6
...


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...
5

Compound Interest and Present Valu

Present Value

Future value calculations provide useful tools for financial planning
...
Present value (also known as
discounting) determines the current worth of cash to be received in the future
...
If the interest rate is 10%, presumably you
would accept the sum that would grow to $1 in one year if it were invested at 10%
...
90909
...
9¢ for a year at 10%, and it will grow to $1 ($0
...
1 = $1)
...
To
illustrate, a $25,000 lump sum amount to be received at the end of 10 years, at 8% annual interest, with
semiannual compounding, would have a present value of $11,410 (recall the earlier discussion, and use
the 4% column/20-period row – $25,000 × 0
...



...
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Analytics for Managerial Decision Making

4
...
Perhaps you are considering buying an
investment that returns $5,000 per year for five years, with the first payment to be received immediately
...
Of course, there is a PRESENT VALUE
OF AN ANNUITY DUE TABLE (see the appendix) to ease the burden of this calculation ($5,000 ×
4
...


4
...
The PRESENT VALUE
OF AN ORDINARY ANNUITY TABLE provides the necessary factor to determine that $5,000 to be
received at the end of each year, for a five-year period, is worth only $18,954, assuming a 10% interest
rate ($5,000 × 3
...
The following graphic confirms this conclusion:

4
...


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...
9

Compound Interest and Present Valu

Challenge Your Thinking

Many scenarios represent a combination of lump sum and annuity cash flow amounts
...
Perhaps the safest approach is
to diagram the anticipated cash flows and apply logical manipulations
...
The building will be vacant for two years while it
is being renovated
...
The building will be sold in five years for $700,000
...

As you can see below, the rental stream has a present value of $285,941 as of the beginning of Year 3
...

The sales price is separately discounted to its present value of $548,471
...
This type
of cash flow manipulation is quite common in calculating present values for many investment decisions
...
54595 – 1
...
59357; $100,000 × 2
...
This result occurs because it
assumes a five-year annuity and backs out the amount relating to the first two years, leaving only the
last three years in the resulting present value factor
...
com

29

Analytics for Managerial Decision Making

Evaluation of Long-Term Projects

5 Evaluation of Long-Term Projects
Now that you have learned some basic principles about how dollars are impacted by compound interest
and present value calculations, let’s see how you can use these tools to make better business decisions
...
These include net
present value, accounting rate of return, internal rate of return, and payback
...
1

Net Present Value

The net present value (NPV) method offsets the present value of an investment’s cash inflows against
the present value of the cash outflows
...
The cost of capital is the theoretical cost of capital incurred by a firm
...
In the alternative,
management may simply adopt a minimum required threshold rate of return that must be exceeded
before an investment will be undertaken
...
e
...
On the other hand, if an investment has a
negative net present value (i
...
, the present value of cash inflows is less than the present value of cash
outflows), the investment opportunity should be rejected
...
Assume that the firm’s cost
of capital is 5%
...
Let’s additionally
assume that the up-front purchase price for the building is $575,000
...
Maintenance, insurance, and taxes on the building
will amount to $10,000 per year, payable at the end of each of the five years
...
This suggests the project’s
returns exceed the 5% cost of capital threshold
...


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...
2

Evaluation of Long-Term Projects

Impact of Changes in Interest Rates

Carefully consider the mathematics (or table values), and you will observe that higher interest rates
produce lower present value factors, and vice versa
...
Perhaps you have considered buying a house or car on credit; in
considering your decision, the interest rates on the deal likely made a big difference in how you viewed
the proposed transaction
...
In simple terms, lower
rates can stimulate borrowing and investment, and vice versa
...
The following spreadsheet shows
how the net present value shifts from a positive net present value of $39,183 (when interest rates are 6%),
to positive $11,067 (when interest rates are 8%), to negative $14,779 (when interest rates rise to 10%)
...


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...
For example, the
“balloon” shows the specific formula for cell H17 – (1/(1+i)n) – where “i” is drawn from cell C17 which
is set at 8%
...
This simple approach allows
rapid recalculation of net present value by simply changing the value in the interest rate cell
...
3

Emphasis on After Tax Cash Flows

In computing NPV, notice that the focus is on cash flows, not “income
...
That is why the illustration
for Markum Real Estate did not include deductions for deprecation
...
Some noncash expenses like
deprecation can reduce taxable income, which in turn reduces the amount of cash that must be paid for
taxes
...
This often entails the preparation of pro forma cash flow statements and
consultation with professionals well versed in the details of specific tax rules!

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...
The land cost is $100,000, and $50,000 is spent to construct a water bottling facility
...
The bottling plant has a five-year life, and is depreciated by
the straight-line method
...
At the end of five years, it is anticipated that the land
will be sold for $100,000
...

The following spreadsheet shows the calculation of annual income and cash flows in blue
...
The
annual net cash flows are then multiplied by the appropriate present value factors corresponding to an
8% discount rate
...
Interestingly, had the annual
net income of $19,500 been erroneously substituted for the $29,500 annual cash flow, this analysis would
have produced a negative net present value! One cannot underestimate the importance of considering
tax effects on the viability of investment alternatives
...
4

Accounting Rate of Return

The accounting rate of return is an alternative evaluative tool that focuses on accounting income rather
than cash flows
...
For Mirage’s project above, the accounting rate of return is 13% ($19,500/$150,000)
...
The decision rule is to accept investments which exceed a
particular accounting rate of return
...
g
...
As a result, by itself, the accounting rate of return can easily misidentify
the best investment alternatives
...


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...
5

Evaluation of Long-Term Projects

Internal Rate of Return

The internal rate of return (also called the time-adjusted rate of return) is a close cousin to NPV
...

In other words, it is the interest rate that would cause the net present value to be zero
...
The IRR would be calculated for each investment opportunity
...
This contrasts with NPV, which has a general decision rule of accepting projects with a
“positive NPV,” subject to availability of capital
...

The manual calculation of IRR using present value tables is a true pain
...
If the available tables are not sufficiently detailed, some interpolation would be needed
...
Let’s reconsider the illustration for Greenspan
...
8361%
...
This rate was selected by a higher-lower guessing process (trying each interest rate
guess in cell C7)
...


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Analytics for Managerial Decision Making

5
...
” It is a popular and
easy method, and can be valuable when the key investment goal is to find projects where the initial
investment is quickly recovered
...

Payback is calculated by dividing the initial investment by the annual cash inflow
...
9 years ($500,000/$128,000 = 3
...
If an investment
involves uneven cash flows, the computation requires scheduling cash inflows and outflows
...

The method is deficient in that it does not take into account the time value of money
...
For example, some investments may payback rapidly, but
have little residual cash flow after the payback period
...
Although the investment with
the shorter payback may be viewed as favorable, it could easily turn out to be the worst choice
...


5
...
There are
many tools at your disposal
...
But, in the final
analysis, good decision making will be driven by your own reasoned judgment
...
com

35

Analytics for Managerial Decision Making

Appendix

Appendix

36



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