The management of a company operates under immense pressure as well as complexity. It is essential for the managers to look after the business from every sphere. Thereby, it is imperative that the decision making of the managers must be done in a manner that will help the overall organization. In tune to this, the managers must use various techniques such as sensitivity, scenario, simulation and break even analysis to ensure effective decision making. Moreover, managers must consider the new projects in an effective manner and hence, capital budgeting technique must be used. The above-mentioned methods can be used in different projects and enable the managers to get the maximum output. The same has been discussed below:
The business functioning is done under immense pressure and complexity. With the due passage of time, there have been considerable changes in the business function and varied factors have come to the forefront. Both the external, as well as internal factors play a vital role in the business functioning. The internal factors are present in the form of internal policies, management, etc. On the other hand, the external factors constitute changes in the demand pattern, framing of new policies, etc. The external factors are not within the control of the business and might disturb the profit element of the business. To keep such a situation at bay, the company utilize a method that helps in assessing the sensitivity of the sales, cost and the variations in the income pattern (Berk et. al, 2015). This method is termed as a sensitivity analysis. it enables to ascertain the variation that is present in the variables and is quantifiable in nature that helps in knowing the project viability.
When it comes to sensitivity analysis, the changes that are not favorable are accounted for so that the influence of the changes can be known on the profitability of the project. Capital budgeting is the main area where the use of sensitivity analysis is prominent. It provides innumerable benefits that are the identification of the main variables that influence the cost and the project benefit (Berk et. al, 2015). Through it, a cost that pertains to operations is traced in this stage. The impact of the amendments is done and the business gets a clear idea whether the change will influence the decision-making ability.
Sensitivity analysis is a tool used by the managers as a risk evaluation tool that strives to evaluate the changes in the variables and assumptions that are underlying because such have a direct impact on the cash flow, as well as the project profitability. The main aim of sensitivity analysis is not to evaluate the risk rather know the responsiveness of the NPV. It provides a strong support to the project manager when it comes to reasoning because they are able to arrive at a course of action and the reason why the plan did not attain the desired result. In the capital budget technique, sensitivity analysis sports the variation that happens in the case of an assumption or estimation of the entire project (Damodaran, 2012).
Whenever any capital budgeting decision is taken certain assumption is required to be made regarding the project like how many units to be sold, project completion time, the cost of capital, etc. it is therefore of utmost importance that assumptions about the project need to be reliable (Vaitilingam, 2010). Sensitivity analysis helps to ascertain the sensitivity of the project in terms of the result to the assumptions that are made. Sensitivity analysis changes any of the assumptions while the other remains unchanged and ascertains how the NPV or IRR changes (Guerard, 2013).
A machine is considered for purchase at an amount of $5,000 more than the base model and leads to saving of cost of over 10% over the span of three years.
Entire cost of running the machine – $20,000 every year
Savings – $2,000 every year
Cost of capital 8%
At this juncture, an assumption is considered for the four things like extra cost if purchasing the machine, percentage of cost savings, cost of running the machine and the cost of capital. By the assumption made, the PV of the savings in cost stands at $5,154, the cost at $5,000 and hence the NPV $154 therefore, the project should be accepted. But, we are not aware of the savings amount and at this juncture, we can use the method of sensitivity analysis (Brealey et. al, 2011). The assumption is now changed to the process of cost savings and other assumptions are left undisturbed. The project desirability is now scrutinized to check the changes.
Scenario analysis is a way of ascertaining the future values of various portfolio investments that rest on some events. In simple terms, it is a way to estimate what will happen to the value of portfolio if a particular event happens or does not happen. The main utilization of scenario analysis can be used in the process of decision making to ascertain the best action for the organization so as to enhance the profit of the company. It can be termed as the best case scenario. This technique can be used for knowing the worst case scenario and predict the losses and other problems in the operations. This process is even used for launching a new product so as to lessen the drop in the sales (Brigham & Daves, 2012). It is equally helpful in terms of capital budgeting when a strong evaluation is required. The NPV of the project can be backed up through this mechanism under the situation of high, moderate and low inflation. It enables to know the possible scenario of the economy that helps the institution while allocating the resources.
For example, a manager wants to create a budget but is not accurate of the income. By utilizing the scenario analysis, he will be able to ascertain the possible manner of income and then use the concept of probability analysis. The worst case scene for the manager is the gross income of $80,000 and the cost of goods sold stands at $35,000. Hence, the manager derives at a gross profit of $45,000.
The best case scenario for the manager is a gross income of $1, 30,000 and cost of goods sold amounting to $40,000 thereby leaving a gross profit of $90,000. To differentiate between the two scenarios, scenario analysis can be effectively used by the manager. Whenever variables and assumptions are involved there is a strong level of uncertainty. Thereby using the process of scenario analysis helps to differentiate between various scenarios and a positive result can be attained. The application of this mechanism is of utmost use when it comes to the process of capital budgeting a strong level of analysis is needed. The possible scenario can be known thereby eliminating complexity and issues.
Break-even analysis is an important method to answer a variety of question that relates to the profitability of the company’s product or services. Its use can be linked either with a product or a service. Most importantly, it can be used to answer questions such as minimum level of sales needed to ensure that the company will not suffer any loss or the sales that must be lessened and still the company remains profitable (Parrino et. al, 2012). While starting a new venture, it is vital to conduct break even analysis because it answers to critical questions like how sensitivity is the business profit in tune to the decline or the increment in the costs.
Break even analysis is used by the manager in capital to ascertain the products or product lines in tune to their volume and profitability. This tool is vital because it is used to know the volume at which the cost of the company will match with the revenues hence resulting in a net income of zero or the breakeven point (Jmaes, 2010). The break even analysis provides a strong understanding in terms of variable and fixed cost. It helps the managers and business to research, ascertain and split the cost of the company into fixed and variable groups. Capital budgeting is done to know the feasibility of the project and breaks even is critical in making the business profitable (Kandel & Stambaugh, 1995). The financial planning of the new project must contain accurate and strong break even analysis to know how the business will shape in the coming scenario and whether the venture should be selected. It is important for the manager to understand the break even so that valid decision can be taken to know whether the business is profitable or not (Graham & Smart, 2012). The formula for the break-even stands:
BEQ FC / (P-VC)
Where BEQ = Break-even quantity
FC = Total fixed costs
P = Average price per unit, and
VC = Variable costs per unit.
When it comes to the break-even in capital budgeting, it is important to understand at which point the revenue will move ahead of the cost. The example is set below:
|
Fixed Costs |
Variable Costs |
||
|
Labor |
$1,000 |
Flour |
$0.40 |
|
Rent |
$2,000 |
Yeast |
$0.05 |
|
Insurance |
$900 |
Water |
$0.02 |
|
Advertising |
$600 |
Butter |
$5.00 |
|
Fees |
$600 |
Pepper |
$2.00 |
|
Total |
$5,100 |
Total |
$7.47 |
As per the current scenario, the total variable cost of a pizza is set at $7.47 or more so that the coverage of the costs can be done with ease. But, if the pizza charges $10 for the goods finished then $2.53 is received per pizza that makes an addition to the fixed costs and hence, the restaurant will earn a profit (James, 2010). Therefore, the management can use the break even to assess the condition. it is of major importance when it comes to the break even chart that leads to a better conduct of the business.
It is an approach that is based on statistics and considers the probability distribution and random numbers that are pre determined in nature to know about the outcomes that are risky in nature. In this method, the manager applies the components of the cash flow in a mathematical model and repeat the method certain number of times (Clark, 2010). Hence, it leads to the development of a probability distribution of returns that are projected in nature. The process of generation of random numbers and utilizing the probability distribution for cash inflow and outflow helps the manager to ascertain the values for every variable. When these values are substituted into the mathematical model it leads to NPV. When the managers repeat the same process innumerable times then the probability distribution of net present values can be created with ease (Bodie et. al, 2014).
Simulation is a potent spreadsheet tool that enables the managers to understand the risk, as well as complexity in discounted cash flow analysis. The benefit of simulation lies in the fact that the method overcomes the shortfalls that are observed in sensitivity and scenario analysis by evaluating the impact of all combinations of every variable (Da et. al, 2012). It is utilized in the case f traditional capital budgeting as it utilizes the sampling form of repeated random from the probability distribution of major variables that lies in the cash flow to derive at output distribution or various profiles that are associated with risk of cash flows in the NPV of the project for a particular plan (Arnold, 2010). Simulation strives to provide a real life decision making by utilizing a model based on mathematic like equations of operations or identities to get hold of the vital functioning of the project because it arrives through random events that are encountered with time. The managers use the process of simulation in capital budgeting is done in a certain number of steps. The modeling is done by the manager in a set of mathematical equation that traces the vital primary variables that include description of the independence that exists between various variables and different time span. The probability distribution is specified for every crucial variable that pertains either subjectively or relates to the empirical data of the past. Further, the utilization of computers has made the simulation feasible in nature (Clark, 2010). The simulation output is certainly an important aspect when it comes to the process of decision-making because it helps the managers to know and trace a risk return trade-offs instead of particular point estimation (Arnold, 2010). Hence, simulation provides the managers with real life scenario and the same can be used to know the feasibility of the project. The best benefit that can be derived through simulation is that simulation can project various assumptions. For example, if a project is considered and provided to the committee with a probability of 99% success and IRR more than the cost of capital. It looks to be a perfect project because of high returns and less chance of failure. On the contrary, when it comes to definition high yielding projects are subjected to high risk because there is nothing without stake (Northington, 2011). Hence, the NPV probability cannot touch 100% as projects that earn the cost of capital are risky too. Therefore, simulation can be used effectively by the managers to detect the bias of the originator of the project.
References
Arnold, G 2010, The Financial Times Guide to Investing, Prentice Hall.
Berk, J., DeMarzo, P. & Stangeland, D 2015, Corporate Finance, Canadian Toronto: Pearson Canada.
Bodie, Z, Kane, A. & Marcus, A. J 2014, Investments, McGraw Hill
Brealey, R, Myers, S. & Allen, F 2011, Principles of corporate finance, New York: McGraw-Hill/Irwin.
Brigham, E. & Daves, P 2012, Intermediate Financial Management , USA: Cengage
Clark, V 2010, Using Monte Carlo Simulation for a Capital Budgeting Project, viewed 14 August 2017 https://www.imanet.org/-/media/125d2e3fa1434a2ca33a95520d373e39.ashx
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 2012, Investment Valuation, New York: John Wiley & Sons.
Graham, J & Smart, S 2012, Introduction to corporate finance, Australia: South-Western Cengage Learning.
Guerard, J. 2013, Introduction to financial forecasting in investment analysis, New York, NY: Springer.
James P. D 2010, Topics in Capital Budgeting, viewed 14 August 2017 https://www.csun.edu/~jpd45767/303/8%20-%20Topics%20in%20Capital%20Budgeting.pdf
Kandel, S. & Stambaugh, R.F 1995, ‘Portfolio inefficiency and the cross-section of expected returns, Journal of Finance’, vol. 50, pp. 157-184.
Northington, S 2011, Finance, New York, NY: Ferguson’s.
Parrino, R, Kidwell, D. & Bates, T 2012, Fundamentals of corporate finance, Hoboken,
Vaitilingam, R 2010, The Financial Times Guide to Using the Financial Pages, London: FT Prentice Hall.
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