Discuss about the Capital Budgeting Techniques Project.
This project discusses about capital budgeting techniques. In capital budgeting how a project is being selected from a different set of alternatives is described. In capital budgeting there are various techniques that can be used, like decision tree analysis, net present value, internal rate of return, average rate of return, accounting rate of return. In the given report some of techniques are discussed like sensitivity analysis, scenario analysis, capital asset pricing model and capital market line (Ross, 2009). However it does not give a guarantee regarding the returns, but provide an expected value through analyzing various models about the future returns under a given portfolio. It is considered as one of the challenging task for a financial manager, as a considerable amount of money would be invested in a portfolio. Hence the decision regarding the portfolio management must be taken seriously.
In a corporate when a decision is taken from a set of different alternatives in order to achieve the organizational goals and objective. This process is called as corporate decision making. It is an integral part of the corporation. This is a continuous process so to run the organizational activities efficiently (McKinsey & company, 2009). The corporate decision making is considered as a process of achieving best results of an outcome.
This analysis is used to analyze the variations in input of a model with the change in circumstances. The changes can be in terms of qualitative and quantitative terms (Wallace). The relevancy of this analysis is to know about the variation in the input variables in case of some uncertainty happened (Bris). This model is used in case to make sure about ensuring the reliability of the project and the quality of the project. However sensitivity analysis is also used in knowing about similarity between the applied model and process, variations in input factors, interaction between factors, factors affecting output variables. This model is used in risk analysis, financial applications, and where the projects are being selected. This analysis is easy to use, communicate. This analysis helps the corporate managers in taking better decisions in relation to achieve breakeven point, cash flow analysis (Chapter 6, Probabilistic approaches).
Sensitivity analysis is used in capital budgeting to get a clear view on to take or not to take a project. In capital budgeting, sensitive analysis changes one assumption at a time in order to analyze the effect on the outcome. Sensitive analysis is used to estimate about the effect on the project if some assumptions turn out to be unreliable (Koining). In capital budgeting, sensitive analysis is highly used. As NPV analysis is also used in capital budgeting, and also tells about the risk analysis, cash flow and break even analysis. But a small change can convert a positive NPV to a negative NPV. That is the reason sensitivity analysis is used in capital budgeting in order to analyze apart from variable costing (Peterson, & Fabozzi, 2002).
This analysis is used to know about the changes in possible outcomes in respect of some alternative outcomes. It defines the average of cash flows in respect to possible circumstances. In scenario analysis the value of an asset of future cash flows are expected so to better understanding about the risk analysis under the given project (Khan & Jain, 2008). In a portfolio which contains a risky project can vary in cash flows. That is cash flows can differ from the expectations. In scenario analysis, it has two case scenarios that are best case scenario and worst case scenario. If the project cash flows meet out the expectations it is said to be as best case scenario (Gitman, Juchau & Flanagan, 2011). Whereas in case the cash flows do not meet out the expectations it is considered as worst case scenario. However this is not reliable because in best case scenario in order to meet cash flows, revenue needs to be generated, and for that cost may be cut down, this would increase in sales but simultaneously increase in variable cost too. While in case of worst case scenarios, as the cash flow are less, which can be due to risk factor. However in scenario analysis besides from best and worst case scenarios, multiple scenarios can be considered with variations in assumption in economic and asset variables. This analysis can be measured for qualitative as well as quantitative analysis (Doss, Sumrall, McElealth & Jones, 2013).
In capital budgeting, in order to select the best portfolio, scenario analysis is used. In scenario analysis two case scenarios are determined. And according to them the amount to be invested in a project is determined (Bedi, 2005). However there can be other assumptions which can affect the decisions in capital budgeting. In big firms, scenario analysis is highly adopted. Although in capital budgeting, NPV is highly preferred, but at the same time it has been criticized in case of variations in assumptions. That is the reason scenario analysis is used in capital budgeting (Lasher, 2014).
CAPM is a technique adopted by investors to know about investing in a project or not. This is done by considering the expecting return at the given risk. CAPM is used to compensate the amount of expected return in terms of time value of money and the systematic risk. In CAPM the risk factor is considered as beta which is compared with return of assets of the market and market premium which is the difference between market risk rate and risk free rate. According to CAPM model the expected return of the security must be compared with the risk free rate and risk premium. If the expected return is not matched with required rate of return, the project must not be undertaken (Sharifzadeh, 2010).
The CAPM model has some assumptions like investors are more interested in wealth generation; investors are free to sell the securities in which they are not interested. Investors are assumed to have same expectations; all the financial assets are fully divisible that is investors can purchase and sell the securities as they wants. All the securities are sold and purchased at market price. The securities do not levies transaction costs. Market prices cannot be influenced by the investors. There are no taxes.
The CAPM equation is Ra= Rf+ β (Rm-Rf)
In the above equation:
Ra= rate of return of the security or portfolio
Rf= Risk free rate
Β= beta factor that is systematic risk
Rm= market rate of return
For better understanding of CAPM model, it can be explained by quoting an example.
Let say there is an asset called ABC, whose Rf= 3%, Rm= 10%, and β= .75. it is required to calculate required rate of return using CAPM model.
The solution to this would be:
Ra= Rf+ β (Rm-Rf)
|
Rf |
Rm |
β |
|
0.03 |
0.10 |
0.75 |
|
Ra= Rf+ β(Rm-Rf) |
||
|
8% |
CML is used in CAPM model in order to determine the required rate of return for the portfolio in respect to the level of risk which is also calculated by standard deviation and risk free rate. It is a line which depicts a relationship between market portfolio and risk free assets. It represents the premium earned by taking extra amount of risk. When a tangent line is drawn from the pint of risk free to the feasible area of risky assets, it is called as capital market line (Capital asset pricing model).
The assumptions of CML model is that all the investors has same expectations on variances and mean. Prices can be adjusted to make the market efficient. The investor will select the assets in his/her portfolio on the basis of risky and risk free assets existing in the given portfolio.
Equation to CML model is:
In the above equation of CML
?=mean,
σ = standard deviation of rate of return in a portfolio
(?M- rf)/ σM = slope of CML
According to this equation, if there is an increase in one unit in standard deviation, the expected rate of return must increase accordingly.
This can be understood by quoting an example. Let say the current price of a security is $875. It is expected to provide return of $1000 in a year. The standard deviation of the return (σ) = 40% and Rf = 10%. It has also been provided that the market rate of return is 17% and σM= 12% for portfolio. It is required to compute that whether the given security is efficient or not (Capital asset pricing model and factor models).
The solution to the given question is
|
Rf |
Rm |
σM |
σ |
Rm-Rf |
Rm-Rf)/σM |
|
0.1 |
0.17 |
0.12 |
0.4 |
0.07 |
0.58333333 |
|
?= Rf + [(Rm-Rf)/σM]*σ |
|||||
|
33.33% |
Graph of CML
According to the CML model all the investor lie upon capital market line. Risk takers rest at right of the efficient frontier line, whereas risk avoiders are at the left of the efficient frontier line.
CAPM consists of two models, those are CML and SML. CAPM and CML model are positively correlated. That is it has been assumed in both the models that the investor would take more risk only when there is an expectancy of getting more returns. Both the models are used by the modern theorist in order to select the best securities in their portfolio. However CML is a part of CAPM (Sigman, 2005).
CAPM model is used for multiple numbers of securities or a number of portfolios rather in a single security. It is highly used by modern theorist also in order to make investment decisions and investing in best portfolio. CAPM model is being used for multiple securities like stock, bonds. CAPM model is used for calculating the fair value of the project by considering the future returns to current returns (Sigman, 2005). The major difference between CAPM and CML is that CAPM holds the securities which can be efficient or non efficient. But in case of CML it consists of only efficient portfolio.
By analyzing capital budgeting techniques, it is recommended that as usually preferred techniques are NPV, IRR, and ARR etc. hence for effective capital decision making, the cash flows to be considered should be at present value. The investor should consider the time value of money. Apart from this the inflow to be considered should be the net cash flow, which is accounting profit should be avoided during capital budgeting decisions. In cash flow manger should do an incremental analysis, in that tax impact should be considered, so as to make effective decision making. It should be adopted by big MNCs but it is advisable that every company should adopt such techniques.
Conclusion
Hence by techniques laid down in the report, it can be said that before investing in a portfolio, risk and return analysis must be done in depth to get an overview of the future returns. However more than one technique in capital budgeting can be used in order to get more assured about the returns. It can also be concluded that the risk and return patterns changes according to the market, which is every market has its own risk and return rate of securities. An analytical process must be followed in case of capital budgeting. By analytical process it is meant that the answers should be finding out before investing in any project. That is, is there a need to invest in a project?, how much amount would be requiring to invest, in what type of securities should be invested, what will be the future cash flows, when the breakeven point would be achieved. There are many other question too which need to be answered depending upon the corporation, and market
References
Bedi,A. (2005 ) Capital Budgeting, Deep & Deep publications, New Delhi
Bris,M. Sensitivity analysis as a managerial decision making tool, Sensitivity analysis as a managerial decision making tool. Retrieved at https://www.efos.unios.hr/repec/osi/journl/PDF/InterdisciplinaryManagementResearchIII/IMR3a9.pdf
Capital asset pricing model and factor models. Retrieved at https://www.math.ust.hk/~maykwok/courses/Fin_econ_05/Fin_econ_05_5.pdf
Capital asset pricing model. Retrieved at https://www.personal.psu.edu/tts3/Files/Fin406/set4.pdf
Chapter 6. Probabilistic approaches: scenario analysis, decision trees and simulations. Retrieved at https://people.stern.nyu.edu/adamodar/pdfiles/valrisk/ch6.pdf
Doss,D,A. Sumrall III, W,H. McElealth,D,H & Jones, D,W.(2013) Economic and financial analysis for criminal justice organizations, Taylor & Francis group, Boca Raton
Gitman,L,J. Juchau,R & Flanagan,J.(2011 ) Principles of managerial finance, Pearson, Australia
Khan & Jain. (2008) Financial management, Tata Mc graw hill, New Delhi
Koining,E. Sensitive analysis for capital budgeting. Hearst newspapers, LLC. Retrieved at https://smallbusiness.chron.com/sensitivity-analysis-capital-budgeting-10153.html
Lasher,W,R. (2014 ) Practical financial management, Cengagae learning, USA
McKinsey & company. (2009) How companies make good decisions: McKinsey global survey results. Retrieved at https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/how-companies-make-good-decisions-mckinsey-global-survey-results
Peterson, P,P & Fabozzi,F,J. (2002), Capital budgeting: theory and practice, John Wiley & sons, Canada
Ross.(2009) Corporate finance, edition 8th, Tata Mc graw hill, New York
Sharifzadeh,M. (2010) An empirical and theoretical analysis of capital asset pricing model, Boca Raton
Sigman,K. (2005) Capital asset pricing model (CAPM). Retrieved at https://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf
Wallace,S,W. Decision making under uncertainty- is sensitivity analysis of any use. Retrieved at https://kursinfo.himolde.no/lo-kurs/lo904/Wallace/Sensitivity.pdf
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