Methods For Capital Budgeting: Sensitivity Analysis, Scenario Analysis, Simulation And Break Even Analysis

Sensitivity Analysis

Question:

Discuss About The Method To Continue Unaltered Equivalently?

It is the role of the management to take a vital decision in regard to the functioning of the company and it can be done with the aid of proper tools and techniques. The management has the option to use tools such as scenario analysis, sensitivity analysis, simulation and break even that helps in driving at a conclusion. It needs to be noted that capital budgeting technique is important as it stress upon selection of various investment proposals and the tools mentioned below are important to the organization so that the best selection can be made. The major emphasis of the task is with the tools and technique in the process of decision making.

Sensitivity Analysis method can be interpreted as the statistical method, useful in analyzing the consequential alterations from the expected assessment of the value. The capital budgeting can be analyzed by studying in the current study. Sensitivity analysis is about determining and assessing the value by which one can revamp the information input to derive the result in a linear-programming method to continue unaltered equivalently (Correia et. al, 2005). The process is helpful in justifying sensitivity in the information provided and used in calculating the much-needed levels at every input to support the authorities in the decision-making process by providing much-needed recommendations and simultaneously constructive in finally examine the intensity of information acknowledged.

Sensitivity analysis concept assists in identifying the aspects of divergent values of independent variables upon the dependent variables under various conditions. Apart from that, capital budgeting method is a process to figure out a project to decide on to the project to be carried out or leave. While analyzing an individual project, only financial aspect is considered by the management of a company in the capital budgeting process, whereas in case of sensitivity analysis method both financial and non-financial aspects are simultaneously taken into consideration by the management of the organization (Kan & Zhang, 1999). That is why management of an organization prefers sensitivity analysis concept over capital budgeting system while evaluating the financial strength of a project under consideration (Brigham & Ehrhardt, 2011). It can be said that management of the company determines and get the sense of the success chances of a project by examining the project through sensitivity analysis system.

Sensitivity analysis concept can be defined as a process in identifying and budgeting the cash inflow and outflow of the project by taking into consideration some fundamental factors such as current economic situation, the rate of inflation and interest rate scenario. Sensitivity analysis can be better defined with the help of IRR and NPV system (Kandel & Stambaugh, 1995). For example, if the management of a company distinguish that net present value (NPV) of a particular project is in negative, then the chances of failure of the project is much high, that indicates that company’s management should not invest into the project, but when the management of the organization examine a project and find that the IRR is 12%, whereas the cost of capital is 6% only, it implies that IRR is much higher than the cost of capital. Therefore, there is much more chances or probability that the project under consideration will be suitable and will be profitable for the company because of a higher rate of return that company can realize by investing into the project to improve the financial aspects of the company and investors.

Scenario Analysis

Scenario analysis is a procedure defined as a process of analyzing a project taking into consideration fundamental factors and expectations or can be defined that the scenario analysis is the procedure of evaluating a project taking into consideration different variety of circumstances. Berk and Van put forth views that the management of a company analyzing a Project going through all possible alternative outcome by considering scenario analysis method. By considering all the risk factors attached to the project can be identified by the experts and the management under scenario analysis is always helpful as mentioned by Habibi and Habibi in its report. Under the guidance of the scenario analysis, the management of the organization can evaluate and judge the impact of any adverse situation on the project undertaken by the management of the company (Brigham & Ehrhardt, 2011). Take the example of Coles Limited, the management of the company carry out the scenario analysis to determine the undermine risks rate of return on capital employed in the project under consideration. Hence, this method is employed by the company in the decision-making process and is an important weapon in the hand of the company.

Scenario analysis can be considered as the method of estimating the expected value of portfolio for a given period. This process allows using in predicting the actual fluctuations in price and amount of the securities in the portfolio or any changes happened due to interest rate scenarios (Abor, 2017).

It is utmost important to take a step to conduct the scenario analysis of the project before investing into the project. The company can take IPR and NPV into consideration while conducting scenario analysis in the project to take stock of different rates regarding cost of capital involved, simultaneously the officers involved in the process of conducting scenario analysis can also determine the IPR and NPV during the period of high inflation scenario and determine the cost of capital in the situation of depression in the economic situation in the market (Abor, 2017).

Scenario analysis process through capital budgeting method also extend support and help the management of the company in overseeing the businesslike analysis into the project under consideration enabling the management of the company in taking an appropriate decision quickly and in the end justifying the investment into the project. The above graph indicates the proposal scenario versus the normal business and this helps in knowing the project feasibility. Accordingly, the selection of the project can be done.

Simulation

Tracking of the probability distribution, random numbers is done on the basis of statistics which are collectively known as Simulation. This process is followed so as to detect the risks earlier. In the given case, the manager repeats a mathematical method innumerable time which includes elements of the cash flow so as to earn profits (Brealey et. al, 2015). Thus, it is a better way which provides a clear vision of the future profits. Variable values can be determined by the generation of random numbers and evaluate the probability distribution for the cash inflows and outflows. The alteration of the variable value is followed by their recording into the model so as to generate the NVP. Repetition of this method easily produces the probability distribution of the NVPB (Brealey et. al, 2015).

The risks and threats involved in the discounted cash flows can be easily detected by following the simulation process which is a powerful spreadsheet item. This process analyses all the possible combination of different variable and thus reaches to a more positive conclusion better than the sensitivity and scenario analysis. This process finds its most use in traditional capital budgeting in which the repetition of the process of generation of random numbers with the probability distribution is followed to conclude different outputs related to the NVP of a particular project which depicts a particular strategic system. The simulation process strengthens the decision made by the manager by analyzing the used model or any other authorized information so as to view the working of the whole system. The simulation process is a mathematical formula by the use of which managers are able to find the chief variables that provide a bright clarification of the bond between the chief highlighted variables and a variety of occasional scenarios. The working of this type of method is seen to be completely based on the data or the records which have been previously tracked and kept for later use and also the use of the chief and crucial variables whose values have been previously deduced.

The main function of this process is to positively affect the decisions made by the manager with evidence (Da et. al, 2012). Evidence about the threats prevailing in the project like risk return trade off are marked in attention to the manager while the vague estimates are tried to be eliminated. Thus, the process of simulation provides the manager to take a more practical and real decision so as to decide the profitability of the undertaken project.      

Break Even Analysis

Cost accounting and capital budgeting are the two sectors which mark the use of break even analysis so as to calculate the profit earnings estimates and the quantity of stock in a undertaken particular project or production line. This type of analysis is used to set a “breakeven point” which is generally referred to as a state when the company has no net income. This means that the cost of the company is aligned with its revenue. The revenue matches the cost and hence, is an important update for the management of the future course of activities (Vaitilingam, 2010). But this analysis is far more useful than just this simple definition. A thorough use of this analysis can enable one to gain information about certain variables and behavior of some costs. The nature of various cost can be known with ease with the help of this technique. This mentioned analysis helps the owner of the company to separate the costs in variable and fixed sectors through deep study and detection.

BEQ  = Fixed cost/ (P-VC)

Where BEQ Break-even quantity

FC Total fixed costs

P Average price per unit, and

VC Variable costs per unit

Costs independent of the alteration of the sales such as equipment leases, insurance, interest on borrowed funds, and administrative salaries are included in the fixed costs category. Moving on to the category of variable costs, this section comprises of direct labor, raw materials, sales commissions, and delivery expenses, but these values are such that are affected by the alteration in sales (Brigham & Daves, 2012). The Contribution Margin can be defined as a crucial module of break-even analysis. This can be evaluated or described by the following procedure: product or service’s price (P) minus variable costs (VC) per unit sold. It is the incremental or marginal analysis that includes the contribution margin concept in it. It keeps a track record of the extra revenue and costs that which is used in association with the latter supplementary element (Damodaran, 2010).

The evaluation of the contribution margin is the first rule in deciding the level of sales for a small business to set a break even, this can be made by deducting the variable costs per unit from the selling price. For instance, if X is $50  and variable cost stands at  $25, the contribution margin is $25. The succeeding rule is to divide the total annual fixed costs by the contribution margin. For instance, a company with a fixed cost of $40,000 and a contribution margin of $25 has to sell 4,000 units to set up a breakeven point. It would be easy to alter this amount to revenue for the company which could set a break even for the year (Guerard, 2013). As per the given case, a BEQ of 4000 units multiplied by an X of $25 per unit produces break-even revenue of $100,000.

It provides the manager to separate the costs into fixed and variable categories. Capital budgeting aligned with break even analysis can put up estimates of the profit making probability of the undertaken project. It provides a vision of the future survival of the project and whether to invest in such a project or not (Ferris et. al, 2010).

Fixed Costs	Variable Costs
Labor	3000	Flour	0.3
Rent	3000	Mustard	0.04
insurance	900	Water	0.03
Promotions	600	Butter	3
Fees	500	Cheese	0.5
Total	8000	Total	3.87

The variable cost stands at $3.87 or more indicating that the coverage cost can be done with ease. But, if the burger charge is raised to $10 for the finished goods then $6.13 will be received in addition to the fixed cost and hence the restaurant will receive profit.

The above study clearly projects that the company’s management can undertake any of the technique depending upon the nature of the project. The suitability of the tool and its implication will determine the decision-making process of the company. The project feasibility can be known with ease with the aid of capital budgeting mechanisms like NPV and IRR. The above study clearly defines that the tools are of potent use when it comes to management decision making. However, the selection of the tool should be completely based upon the nature of the project and feasibility.

References

Abor, J.Y 2017, Evaluating Capital Investment Decisions: Capital Budgeting, In Entrepreneurial Finance for MSMEs, Springer International Publishing.

Brealey, R. A, Myers, S. A & Marcus, A. J., 2015, Fundamentals of Corporate Finance, 8th ed, Australia: McGraw-Hill Irwin.

Brigham, E. & Daves, P 2012,  Intermediate Financial Management , USA: Cengage

Brigham, E.F. & Ehrhardt, M.C 2011, Financial Management: Theory and Practice, USA: Cengage Learning.

Correia, C, Mayall, P, O’Grady, B & Pang, J., 2005, Corporate Financial Management, 2nd ed. Perth: Skystone Investments Pty Ltd.

Da, Z., Guo, R.J. & Jagannathan, R 2012, ‘CAPM for estimating the cost of equity capital: Interpreting the empirical evidence’,  Journal of Financial Economics vol. 103, pp. 204–220

Damodaran, A 2010, Applied Corporate Finance: A User’s Manual, New York: John Wiley & Sons

Ferris, S.P., Noronha, G. & Unlu, E 2010, ‘The more, merrier: an international analysis of the frequency of dividend payment’, Journal of Business Finance and Accounting, vol. 37, no. 1, pp. 148–70.

Guerard, J. 2013, Introduction to financial forecasting in investment analysis, New York, NY: Springer.

Kan, R. & Zhang, C 1999,  ‘Two-pass tests of asset pricing models with useless factors’, Journal of Finance, vol. 54, pp. 203-235.

Kandel, S. & Stambaugh, R.F 1995, ‘Portfolio inefficiency and the cross-section of expected returns, Journal of Finance’, vol. 50, pp. 157-184.

Vaitilingam, R 2010,  The Financial Times Guide to Using the Financial Pages, London: FT Prentice Hall.