Concept Of Sensitivity Analysis In Capital Budgeting

Introduction to Sensitivity Analysis

Discuss about the Concept Of Sensitivity Analysis.

Sensitivity Analysis can be thought of as a way to better the communication between the frame workers and the decision takers as it sets up a much more convincing, trustworthy, credible and comprehensible media of networks between the two. The sensitivity analysis also provides a medium to check the quantification and the details about a particular process so as to provide information of the relationship maintained between different input and output variables (Tian, 2013). This analysis is of great significance as its help in building a framework which can detect the loopholes in the project.   

Sensitivity analysis provides numerous ways for the management to detect and measure the flaws in the invested project. This analysis also proves to be boon to the management when a matter of a major variable deviation is concerned. In such cases, it helps the management in estimating the circumstances that would follow. This analysis is also useful in detecting the basics of a project which can be modified to get better results. The undertaking of a project always has some threats involved and no organization can guarantee of earning profits. But the company still tries its level; best to eliminate the threat as far as possible by keeping an eye on the procedures so as to earn some capital. It is largely seen that sensitivity analysis is always followed before owing to a new venture (Damodaran, 2012). This process helps to detect the flaws in the venture and thus eases the way to earn profits by altering the net profit amount of the undertaken project. It is the duty of the manager to highlight the threats involved in the venture taking into attention that the sensitivity analysis is thoroughly followed and the threats involved in the undertaken project are detected on time.

Thus from the above explanation, it is proved that the sensitivity analysis is a keen way to get an estimate of the positivity that the project will achieve in the upcoming years. The present financial condition, interest rates, and inflation rates are some of the deciding factors that were followed while detecting or budgeting the cash inflows and outflows as per Graham & Smart (2012) which thought that sensitivity analysis was a process to be followed while performing the above two operations. When it comes to capital budgeting then the sensitivity analysis can be used in association with NVP and IRR which yields better results. In a case let the IRR be recorded as 10% and the cost recorded as 5%. In such matters, the IRR is seen to be greater than the cost of the capital. These types of ventures are very much beneficial for the company as the rates of return from the projects are high which will also attract the investors (Pianosi et. al, 2015). If the above case is vice-versa then the company will be bound to suffer a loss and thus the company is advised not to undertake such a venture.

Importance of Sensitivity Analysis in Capital Budgeting

Sensitivity analysis can also be used in a way to measure interest rates so as to reinvest the return in any other beneficial project for gaining capital. This kind of analysis also provides a way to put an estimate of the values of the project on the basis of major situations. All the alteration in the values is based on the current situation known as the scenario that follows the principle of analysis. Scenario Analysis has proven to be a method that can be relied upon so as to detect the threat in the undertaken project which can be minor or massive fully depending on the situation that prevails during the project undertaking. The records presented after the analysis can be a boon to the investors in knowing the risks which prevail on their part.

A whole lot of ways are open for grabbing a plot of scenario analysis. From many possible ways of seeking this analysis the way of collective analysis is explaining the standard of monthly or daily returns on security and then computing the expected value of every portfolio that create profits having their standard deviation lower or above than the average rate of return. By using this type of analysis the estimator can have a vision of the guarantee about the changes in the value of the portfolio during a fixed span of time.

Scenario analysis provides a clear cut way to measure the successfulness of the investment so as to depict the circumstances that prevail due to the alteration in the value of certain variables and portfolios. If the respected person is an investor then he can make use of the scenario analysis in such a way so as to get an idea of the financial position of the company while claiming credit purchase which is different from storing funds in the form of cash purchases. Apart from the investors the company too can use the scenario analysis to find out the probability of the successful outputs arising from the decisions finalized over a matter (James, 2010). For example, selecting one out of the two storefronts and facilities from the organizational functions can be undertaken. All these processes may include discussions about alternation in fees, fees comprised with utilities and any kind of positivity or insurance that may be grabbed from one end but not from the other.

The method of scenario analysis is a detecting process to check the success ratio of a particular project. It can be seen upon as a scanning method as per the circumstances that prevail during the moment. Berk and Van Binsbergen said that this analysis is the perfect way of finding all the probable outputs about the successfulness of the undertaken project. It is even remarked that this process is crucial in detecting the flaws and risks that prevail in the undertaken project. By using this process it is easy for the management to detect any of the serious situations that arise during the project undertaking (Brigham & Daves, 2012). For example, the Woolworths Limited during the expansion of their business always follows to conduct the scenario analysis so as to detect any prevailing risk.  

Benefits of Sensitivity Analysis

It is always important to follow the scenario analysis so that the flaws in the particular project can be detected. The company can also be in a beneficial state if it keeps an eye on the rate of the NVP and also on the IRR which is recorded during work so as to gain much more capital than expected. It is also very much necessary for the company to keep a track of both NVP and IRR not just during the time of project undertaking but at different times like inflation and also during the depression (James, 2010). Overall discussion proves that the scenario analysis proves to be a boon which helps the organizat6ion to take faster and accurate decisions.        

Break even analysis is a potent tool as it helps in answering various questions that pertain to the company’s profitability relating to the product or the service. It helps in answering several questions like the minimum sales that are needed so that the company does not face any loss or the sales do not decline. Before venturing into a new project, it is important that to conduct a break even analysis as it leads to answering questions that are critical in nature such as the sensitivity of the profit of the business in relation to the increase or decrease in the sales (Guerard, 2013). The break even analysis gives a strong knowledge of the variable and the fixed cost that is associated with the business. It supports the manager to research and segregate the cost of the company into the fixed and variable cost. The feasibility of the project can be done with the aid of capital budgeting and break even helps in making a critical decision so that the venture can be profitable (Vollmer, 2014). The break even analysis will help to know how the business will shape up in the upcoming scenario and if the venture should be selected.  The manager must know the break even so that proper decision making can be done and is projected with the help of the formula:

BEQ FC / (P-VC), Where BEQ = Break-even quantity

FC = fixed costs

P = Average price per unit, and

VC = Variable costs per unit.

When it comes to the aspect of break even in capital budgeting. It is vital to know at what point the revenue will exceed the cost. A hypothetical example has been set below

Fixed Costs	Variable Costs
Labor	$2,000	Flour	$0.20
Rent	$2,000	Yeast	$0.05
Cost of insurance	$800	Water	$0.02
Advertisement	$500	Butter	$4.00
Technical Fees	$400	Pepper	$1.00
Total	$5,700	Total	$5.27

Uses of Sensitivity Analysis

Going by the example above, the variable cost of the burger stands at $5.27 or more which means that the cost coverage can be done easily. However, if the charge of the burger peaks $10 for the finished goods than $4.73 will be received as an addition to the fixed cost and thereby the restaurant will have profit. Hence, the break even concept can be used to know the business performance.

It can be defined as a process that dwells on statistics and observes the probability distribution, random numbers. Such is determined in advance so that the result that is risky in nature can be known or traced. In this scenario, the manager puts to practice the elements of the cash flow in a model based on mathematics and replicate the method various times (Wang et. al, 2016). Hence, it is an effective mechanism that results in enhancement of the probability distribution of returns that are highlighted.  The method of development of random numbers and using the probability distribution for the inflow of cash and outflow enables the managers to know the value for each variable (Berk et.al, 2015). When the submission of the values happens then substitution of the values happens into the model and provides the NPV. When the same mechanism is repeated then the probability distribution of NVPB can be generated in an easy manner.

Simulation can be defined as a strong spreadsheet tool that helps the managers to know the risk and the complexity that is involved in the discounted cash flow analysis. The main advantage of the simulation appears in the case that the mechanism covers the shortfalls that are seen in sensitivity and scenario analysis by assessing the effect of all variable combinations.  The utilization is mainly seen in the case of traditional capital budgeting because it considers the form of sampling of repeated random from the distribution of probability that is based on the cash flow to come to the different profile that is linked to the cash flow in the NPV of a project for a specific plan (Brealey et. al, 2011) Simulation provides solidity to the real time decision making by using the model that is linked to equations or any identity so that a better view of the functioning can be gathered. This method is used by the managers as a mathematical equation that finds the variables that are primary in nature that contains a vivid elucidation of the freedom that finds the important primary variables and contains the description of the freedom that appears between the variables and various time scenarios.  This method is well directed to the major variables and links to the data of the past. This is a vital aspect when it relates to the process of decision making (Northington, 2011).  This helps the managers to understand the concept of risk return trade off rather depending on specific estimation. Therefore, simulation helps the managers to come up with a real life scene and the same can be utilized to know the project feasibility.

If a project has a probability of 98% success and IRR stands more than the capital it will appear that the project is strong and contains minute chances of failure. On the other hand, when it is involved in projects that are high yielding they are subjected to high risk and nothing appears without a stake. Therefore, the probability of the NPV cannot reach 100% as a project that earns the capital cost is riskier in nature (Parrino et. al, 2012). Hence, simulation can be used by the managers to trace the prejudice of the project developer.

References

Berk, J., DeMarzo, P. & Stangeland, D 2015,  Corporate Finance,  Canadian Toronto: Pearson Canada.

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

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 7 September 2017 https://www.csun.edu/~jpd45767/303/8%20-%20Topics%20in%20Capital%20Budgeting.pdf

Northington, S 2011, Finance, New York, NY: Ferguson’s.

Parrino, R, Kidwell, D. & Bates, T 2012, Fundamentals of corporate finance, Hoboken,

Pianosi, F., Sarrazin, F & Wagener, T 2015, ‘A matlab toolbox for global sensitivity analysis’, Environmental Modelling & Software, vol. 70,  pp.80-85.

Tian, W 2013, ‘A review of sensitivity analysis methods in building energy analysis’, Renewable and Sustainable Energy Reviews, vol. 20, pp.411-419.

Vollmer, M 2014, A Beta-return Efficient Portfolio Optimisation Following the CAPM: An Analysis of International Markets and Sectors. Springer.

Wang, C.P., Huang, H.H. & Hu, J.S  2016,  ‘Reverse-Engineering and Real Options–Adjusted CAPM in the Taiwan Stock Market’, Emerging Markets Finance and Trade, pp.1-18.