Scientific decision making

Decisions can be taken by intuition (fast, cheap, uses experience — but subjective and unaccountable) or scientifically, using data and models.

The scientific cycle: set the objective → gather data → analyse the options → make the decision → implement → review against the objective.

• + Reduces risk, is evidence-based, forces the assumptions into the open and can be justified to shareholders and lenders.
• − Slow and costly, depends entirely on the quality of the data and the probabilities used, and can crowd out creativity and entrepreneurial flair.

Decision trees and expected values

A decision tree maps choices (□ decision nodes) and chance outcomes (○ chance nodes) with their probabilities and payoffs.

Evaluate the tool: trees force probabilities and payoffs to be stated explicitly and compare options on one measure. But the probabilities are estimates, payoffs ignore qualitative factors (brand damage, staff morale), and the model assumes the decision-maker is risk-neutral. A small firm may reject the higher EV because it cannot survive the downside.

Your turn — expected value

Your turn — the rival option

Quick check

Investment appraisal — payback

Investment appraisal judges whether a capital project is worth the money. Three methods:

After 2 years, £180,000 is still outstanding, and year 3 brings in £200,000. So payback = 2 + (180,000 ÷ 200,000) = 2.9 years (2 years and about 11 months).

+ Simple, focuses on cash and liquidity, useful in fast-changing markets. − Ignores everything after payback and ignores the time value of money.

Your turn — payback period

Average rate of return (ARR)

+ Uses all the cash flows and gives a % that is easy to compare with interest rates. − Ignores the timing of cash flows and the time value of money.

Your turn — average rate of return

Net present value (NPV)

Money in the future is worth less than money today. Discounting converts future cash flows into present values using discount factors.

With an initial investment of £480,000: NPV = 497,200 − 480,000 = +£17,200 → accept.

+ The only method that accounts for the time value of money and uses all cash flows. − Complex, and hugely sensitive to the discount rate chosen — a higher rate can flip the decision.

Your turn — net present value

Sort the appraisal methods

Tap a statement, then tap the method it describes.

Risk, uncertainty and contingency planning

Risk can be quantified — you can attach a probability to it (a 1 in 20 chance of machine failure), so it can be insured against or built into a decision tree. Uncertainty cannot: a pandemic, a war, a sudden technological breakthrough.

• Contingency planning — a documented "what if" plan: crisis management teams, back-up suppliers, IT disaster recovery, buffer stock, insurance.
• + Faster, calmer response; protects reputation and reassures stakeholders. − Costs time and money for events that may never happen; a plan can create false confidence if it is never rehearsed.
• Business continuity and crisis communication matter as much as the operational fix — the reputational damage often exceeds the direct cost.

Judgement: the value of contingency planning depends on the probability of the event and the severity of the consequences. Low probability plus catastrophic consequences (a data breach) still justifies heavy spending.

Match the technique to its meaning

Tap a card on the left, then its partner on the right.

Quick check

Sensitivity analysis and criterion rates

Appraisal figures rest on forecasts. Sensitivity analysis asks: what if we are wrong? Recalculate the NPV or payback with, say, sales 15% lower or costs 10% higher, and see whether the decision still holds.

• Firms set a criterion rate — a minimum acceptable ARR or a maximum acceptable payback period — and reject anything that fails it.
• Qualitative factors that no model captures: the effect on staff, the brand, the environment, and the firm's objectives and appetite for risk.

Use the methods together. Payback tests liquidity, ARR tests profitability, NPV tests value once time is priced in. Where they disagree, the judgement depends on the firm's cash position and time horizon.

Your turn — sensitivity to the discount rate

Quick check