Capital Budgeting Decision And Analysis

Sensitivity Analysis in Capital Budgeting

Discuss about the Capital Budgeting Decision and Analysis.

The sensitivity analysis which is also known as what if analysis and stimulation analysis is considered very important for decision making as it tells us that whether the estimations are right or wrong. The sensitivity analysis is an approach made to determine how the values of an independent variable affect some other variable which is dependent on various situations are completely different. An analysis of the influence of decisions and its impact on different variable becomes very simple with the help of this approach. The analysts use it to determine how the change of one variable affects the other variables. The sensitivity analysis has a very limited scope. For example, the effect of change in the rate of interest.

It can be well understood with the help of the sensitivity analysis the various possible outcomes and whether the estimations made were correct or incorrect. Sensitivity analysis also helps us to know and measure the impact or the influence on the finances due to the changes in the estimations that were made. This analysis is a used as tool which has helped the managers to identify the reason for not achieving expected targets and helps them to take certain corrective steps to rectify the mistakes in future. Such steps help the company in improving and taking good decisions for the investments. It is not necessary that the estimations will match will the actual result. So in capital budgeting, Sensitivity analysis depicts the changes in the assumptions.

This can be better explained with the help of an example; a company estimated that it would generate $700 each year for consecutive three years.  A decision was taken by the investors to invest $2100 in the first year itself based on their expectations. However, the investors found that there was a change at the end of the first year. The expectations of the investors increased seeing the companys performance and it expected that the company would generate $1400 for the remaining two years. This would breakeven the investment in the second year itself. Therefore, it can be concluded that sensitivity analysis is very useful in determining the changes and its effects.

A sales manager Mr. Zen was keen to know and understand the effect of more customers on sales. Based on the information he comes to know that the sales are a function of price and the transaction volume. In the previous year Mr. Zen sold 100 pieces of the goods, the selling price of each good was $1000. So, he could generate revenue of $100000. The sales managers finds out the customer behaviour and finally draws a conclusion that if the customer’s base is increases by 10% then the sales volume will also increase by 5%. We can say that any change in the customer base will affect the sales of the company. Such information is very useful in building a financial equation. The relevance of Sensitive analysis can also be understood with the help of this example.

Relationship between Sensitivity Analysis and Capital Budgeting Techniques

We know business has a dynamic nature and there are many uncertainties today. So, Scenario analysis works as an analytical tool which is useful for ascertaining the possible outcomes. This is an analytical tool and should not be regarded as a predictive mechanism. There are three scenarios which the analyst uses to identify the possible outcomes. They are best case, base case and worst case. The best case is the one in which it is assumed that everything will move in a correct manner and the worst case is just the opposite in which it is assumed that all the assumptions will be a failure. This makes the analyst proactive and he takes steps before there is a situation of worst case. The analyst does not know what exactly will happen but he gets the idea of the situations that may arise.

In capital budgeting we make estimations which may differ from the actual outcome, in order to eliminate any kind of confusion in the process of decision making we extend the sensitive analysis to scenario analysis. In scenario analysis, one of the method is using the extreme situations. In case of Scenario analysis, a preventive step is already taken from before so that the results are positive. This is because the worst case and the base case can be compared with the base case.

It is very important to look at different aspects of an investment plan to make a wise decision. This decision can be efficiently taken with the help of two tools namely Sensitive analysis and Scenario analysis. The two tools that are used are in no way similar to each other (Peterson Drake and Fabozzi, 2002). A sensitive analysis informs the investors about the uncertainties that may arise whereas the scenario analysis helps us to determine the different possible outcomes and its effects. Therefore, we can say that a scenario analysis may involve the use of sensitive analysis but it is not necessary that the sensitive analysis will involve the use of scenario analysis. The sensitive analysis is totally based on assumptions but the scenario analysis is a test which depicts all the possible outcomes.

We can draw conclusion that Sensitive analysis and Scenario analysis both play a major role in preparing the best plan. It is very relevant for Capital Budgeting. It is not necessary that both the tools move in opposite direction, there are certain situations where both of them move in same direction also. These tools help the investors to prevent taking wrong decision and also provide them a mere idea of the future consequences. It makes them pro active and so they are able to stop themselves from taking wrong decisions. The analysts are greatly helped because of these tools which help them to analyse the uncertainties and take further steps to prevent it. If the outcomes are positive it also provides information about the field of improvement.

Example of Sensitivity Analysis

The capital asset pricing model is one of the most useful and famous methods of financial management which is used to calculate the required rate of return. The sensitivity of any particular asset to its unsystematic risk is taken into consideration with the help of this method. The unsystematic risk is also known as the non-diversifiable risk. The symbol that is used to denote risk is Beta. This Beta is the sensitivity of asset with respect to any movements happening in the market. 

Capital asset pricing model can be better understood with the help of the following equation.

Re= Rf+(Rm-Rf) β

Re stands for the required rate of return, Rm stands for the returns from the market, Rf stands for risk free returns and Beta (β) is the risk.

In order to understand this model more properly we first have to understand this equation and its components more properly. Risk free returns include returns from investment in government bonds and securities, these returns are the benchmark. The return in these kind of investments are generally low and only those people who are scared of taking risk invest in such bonds. Rf provides a little higher risk than Rf but only those people who are not risk averse invest in such securities. The rate of market index is easily determined with the help of Rm. Any movement in the market affect the returns on the asset is measured using Beta. These are all the components that are used to calculate the expected or required rate of return using capital asset pricing model.

The efficient frontier to the capital asset pricing model is the capital market line. Any point on the capital market line shows the efficient portfolio which is made by using both return on market portfolio and risk free returns. The area which is below the capital market line is inefficient and will not let the investors get returns upto their expectations. Similarly, it is also not feasible for investors to invest their funds over the capital market line. Standard deviation is used to measure the risk involved in the investment. The capital market line is one of the most efficient line which helps the investors to determine the risk and ascertain the expected rate of returns.  The main purpose is to show the allocation between the risk free return and risk market portfolio.

An investor should analyse the degree of risk involved before taking any kind of investment decision.  It is with the help of modern portfolio theory that how the investors can invest in risk free and weighted assets in order to get returns. We have also studied that with the increase in the risk the returns also increases. To understand this concept more properly, capital asset pricing model is used which helps the investors maintain a balance between the required rate of return and the existing market factors.

Scenario Analysis in Capital Budgeting

There are a number of similarities between the capital asset pricing model and the capital market line (Bierman and Smidt, 1993). Both these model makes the decision making of the investors easier as it help them to measure the risk involved both in risk free and risk weighted assets.  These theories are based on the same assumptions that all assets are correctly priced and that the market is in equilibrium. The theme of both these models is that the investors are considered rational and they invest is such a manner that the unsystematic risk is eliminated. The Beta covers the portion of systematic risk which is very relevant. Another similarity between both the models is that both of them are useful for calculating the market return for a portfolio mixed having the same factors. It is considered that all the investors have same expectations and all of them are considered rational.

Now lets us understand the differences between the two models. We have already discussed about the fact that how capital asset pricing models help the investor balance is portfolios and capital market is one of the most prominent  and efficient frontier to capital asset pricing model. Although the CML is majorly used for allocation of funds to make a perfectly balanced portfolio, the CAPM is used mostly for the purpose of security pricing. A capital market line is included in the capital asset pricing model whose slope is represented using the Sharpe’s ratio. The return earned per unit of risk taken is the Sharpe’s ratio. When we represent both the model in a single graph, then we can see that the capital asset pricing model covers a wide area as compared to the capital market line. The capital asset pricing model depicts all the possible combination of risk free and risk weighted assets to the investors whereas the capital market line shows the best possible combination available in the CAPM. The CAPM model represents both the efficient and inefficient portfolios whereas the CML represents only the efficient portfolios. If we take a portfolio in a CAPM world we will see that it is not necessarily on the capital market line, this is because the capital asset pricing model is concerned only with systematic risk. The efficiency of the capital market line is comparatively more when compared with the that of capital market line.

We can conclude that both the model move in same direction when it comes to investment management. There are many differences in the theories but these have a common theme which is used by the investors and the portfolio managers to maintain a balance which is according to the investors wish and his expectations. These models provide proper information to the investors so that they make a wise decision for the investment plan and achieve the expected returns. These models play a major role in capital budgeting and so is considered very relevant.

References:

Bierman, H. and Smidt, S. (1993). The capital budgeting decision. 1st ed. New York: Macmillan Pub. Co.

Peterson Drake, P. and Fabozzi, F. (2002). Capital budgeting. 1st ed. New York, NY: Wiley.