Last updated on Aug 3, 2024

How can you evaluate the financial impact of your decisions?

Making decisions is a crucial skill for any professional, especially when it comes to managing resources and achieving goals. But how can you measure the financial impact of your choices and assess their effectiveness? In this article, we will explore some methods and tools that can help you evaluate the costs and benefits of your decisions and improve your decision-making process.

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1 Identify the problem and the alternatives

The first step in evaluating the financial impact of your decisions is to clearly define the problem you are trying to solve and the possible solutions you can choose from. You should also consider the objectives, constraints, and criteria that guide your decision-making. For example, if you are deciding whether to invest in a new project, you should identify the expected return, the required capital, the risks, and the opportunity cost of not pursuing other options.

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Nev Kraguljevic, MBA, CSLP

Financial Planner | Tailored Financial Solutions for Every Stage of Life
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Sometimes a decision is made for us, for example software must be updated else the entire venture is gone. Other times, we are faced with multiple options at which point calculating the Internal Rate of Return (IRR) can be quite helpful. It represents annualized percentage return one can expect over the holding period. If the IRR is greater than your required rate of return or cost of capital, the project might be viable. If you have multiple options, higher IRR option would potentially be a better choice, especially if risks associate with project and capital requirement are similar. However, consider timing of cash flow, alignment with your objective, and potential additional costs (time and money) to make a decision.

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Igor Groenewegen-Mackintosh, LLM

Finance & Tax Leader | Passion for Tech
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Agree that the internal rate of return (IRR) is considered to be a common way to compare projects / solutions. It can be used to make an informed decision which projects to approve and, perhaps more importantly, to reject. The higher the IRR, the better the expected financial performance of the project; the higher the expected return to the company. It is also sensible to combine the IRR with NPV (Net Present Value; to understand profitability) and WACC (Weighted Average Cost of Capital; to understand the cost of capital). When e.g. NPV is negative and IRR is less than the WACC, a project will be rejected. On the opposite, positive NPV and higher IRR than WACC, the project will most likely be prioritized.

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M Charlina Watson

President and Founder at Children Here Are Really Special, Inc.
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One thing I have found helpful is keeping up with best practices in your perspective field. By doing so, the organization can not only have the updated available tools to enhance and promote their organization but it provides a bridge in the operations of your business in a professional manner. It is also instrumental in performance of staff in the most efficient and effective manner which creates sustainability. Decision making is a core component of operating any business and is necessary to gain viability and credibility in your industry. It is important for leaders to possess the skills and knowledge to induct these practices into the organization and accept a place in the industry that provides competitive advantage and presence.

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2 Estimate the cash flows and the discount rate

The next step is to estimate the cash flows associated with each alternative and the discount rate that reflects the time value of money and the riskiness of the project. Cash flows are the inflows and outflows of cash that result from your decision, such as revenues, expenses, taxes, and initial outlays. The discount rate is the interest rate that you use to calculate the present value of the cash flows, which is the amount of money that they are worth today. You can use various methods to estimate the discount rate, such as the weighted average cost of capital, the capital asset pricing model, or the internal rate of return.

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3 Calculate the net present value and the profitability index

The third step is to calculate the net present value (NPV) and the profitability index (PI) of each alternative. The NPV is the difference between the present value of the cash inflows and the present value of the cash outflows. The PI is the ratio of the present value of the cash inflows to the present value of the cash outflows. Both measures indicate the profitability and the efficiency of an investment. Generally, you should choose the alternative that has the highest NPV or PI, as long as it meets your other criteria and constraints.

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4 Perform a sensitivity analysis and a scenario analysis

The fourth step is to perform a sensitivity analysis and a scenario analysis to test the robustness of your decision and to account for uncertainty and variability. A sensitivity analysis shows how the NPV or PI changes when you vary one or more key variables, such as the discount rate, the growth rate, or the cost. A scenario analysis shows how the NPV or PI changes when you consider different combinations of variables, such as optimistic, pessimistic, or most likely outcomes. These analyses can help you identify the main drivers and risks of your decision and to adjust your assumptions and expectations accordingly.

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Igor Groenewegen-Mackintosh, LLM

Finance & Tax Leader | Passion for Tech
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Sensitivity analysis and scenario analysis could be introduced at step 2 already - when estimating the cash flows and the discount rates. As far as I am concerned, getting started early with scenario and sensitivity planning supports efficient preparation of a business case.

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5 Compare the qualitative and quantitative factors

The fifth step is to compare the qualitative and quantitative factors that affect your decision and to weigh their relative importance. Qualitative factors are the non-financial aspects of your decision, such as the social, ethical, environmental, or strategic implications. Quantitative factors are the numerical and measurable aspects of your decision, such as the NPV, PI, or payback period. You should balance both types of factors and consider how they align with your vision, mission, values, and stakeholders.

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6 Review and monitor your decision

The final step is to review and monitor your decision and to evaluate its performance and outcomes. You should compare the actual results with the expected results and identify any gaps or deviations. You should also analyze the feedback and the lessons learned from your decision and use them to improve your future decisions. You should also be flexible and willing to revise or modify your decision if the situation changes or new information emerges.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you evaluate the financial impact of your decisions?

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2

3

4

5

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1 Identify the problem and the alternatives

2 Estimate the cash flows and the discount rate

3 Calculate the net present value and the profitability index

4 Perform a sensitivity analysis and a scenario analysis

5 Compare the qualitative and quantitative factors

6 Review and monitor your decision

7 Here’s what else to consider

Decision-Making

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How can you evaluate the financial impact of your decisions?

1

2

3

4

5

6

7

1 Identify the problem and the alternatives

2 Estimate the cash flows and the discount rate

3 Calculate the net present value and the profitability index

4 Perform a sensitivity analysis and a scenario analysis

5 Compare the qualitative and quantitative factors

6 Review and monitor your decision

7 Here’s what else to consider

Decision-Making

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