Describe about the Corporate Finance for Companies Under Various Situations.
1. Management of the companies under various situations use scenario and sensitivity analysis to arrive at proper decision making. A proper decision making which involves lot of situations under which one needs to input in key variables and then see the output. A typical situation when scenario analysis is used are like business decision making, capital investment decisions. Sensitivity analysis involves changing inputs constantly to see what would be the possible output under different levels of input. This kind of analysis helps in better understanding of the scenario and sensitivity that different inputs can have on the output. It is very important to understand that business output can have different levels of achievement under different situations. Each of this situations can lead to different kind of output and hence it is very important that one understands about it. Management of the company would like to see what can be the degree of sensitivity. The degree of sensitivity can helps one understand what the possible impact is and whether or not one should take the business decision of yes. Let us understand this with an example (Aksenov, 2015).
Company X wants to invest in a project whose returns are dependent on the economy. Let us say that in case the economy is aggressive project will have a return of 18%, if economy is moderately growing it will have a return of 8%, while if the economy is on recession it will be returning 2%. This is scenario analysis, this kind of situations can help the management understand whether or not to take the project.
In another case if the output of production is related to resource planning in the company and output is also a function of how the company perceives demand in the market. In this situation it can be good for the management to have an output which will help them see what would be the desired production levels under different demand scenarios and what kind of sensitivity it will develop in the resource planning. This can also be seen from a different side where the fixed variable is demand and resources, then what would be the capacity utilization of the company.
This decision making techniques already involves lot of measurement methods like NPV, IRR, and payback period. However it could be interesting for the management to see how at different cost of capital levels the key project evaluation parameters like NPV, IRR and payback period changes. Project evaluation methods are very critical, however implementing different sensitivity and scenario analysis techniques can take it to another level. It is very important to understand that project appraisal methods like these involves lot of scenario based assumption. Businesses approves project on the risks that even in worst case scenario the losses would be minimized. This is why it would be very important for any management of the business to have a look at all the possible outcomes of a particular project under different levels of input. This also helps the management in maximizing the returns of a project by providing the maximum level of resources which are available for the project (Aksenov, 2015).
Sensitivity analysis in particular helps in knowing the degree of sensitivity that a project faces against different input variables. Business houses and the respective management has used it extensively for years to figure out on what would be the best situation for a particular project to work. Sensitivity analysis actually helps in figuring out the degree to which the output is sensitive to a particular input variable for the company. The input variables helps in designing and optimizing the inputs in this case which can result in maximizing the input. Let’s say if the sensitivity analysis of a stock investment recommendation suggests that if the cost of the capital of the company rises by 2%, then the share price of the company will fall down by X%. The management of the fund house who intend to see such analysis for investment purpose can then see what is the actual probability of cost of capital rising by 2% in the near term for the investment potential company.
IRR, NPV and payback period are indicators which are based on the cash flow from a particular project. But what if that a particular variable in the whole project has the capacity to actual distort the cash flow. It will in turn change the IRR, NPV and payback period completely. This is the reason why it is very important to build in a sensitivity analysis model and also a scenario based model, this actually helps in making better decisions. A proper decision making which involves lot of situations under which one needs to input in key variables and then see the output. A typical situation when scenario analysis is used are like business decision making, capital investment decisions. Sensitivity analysis involves changing inputs constantly to see what would be the possible output under different levels of input. This kind of analysis helps in better understanding of the scenario and sensitivity that different inputs can have on the output. It is very important to understand that business output can have different levels of achievement under different situations. Each of this situations can lead to different kind of output and hence it is very important that one understands about it. Management of the company would like to see what can be the degree of sensitivity. The degree of sensitivity can helps one understand what the possible impact is and whether or not one should take the business decision of yes.
2. Capital Asset pricing model (CAPM) helps in determining the cost of equity for a particular entity. While this cost of equity when is mapped under different inputs will provide us the Capital market line (CML) which in turn can be used to determine and optimize the actual cost of equity for the company. Historically CAPM models have been extensively used by companies to determine the cost of equity and then work out the fair price of the asset by using the same as discounting rate. This is subject to the fact that cost of asset acquisition only involves equity. In case it involves debt one need to do a weighted average of the debt and equity proportion to determine the cost of capital. CML model helps in optimizing the variables so that company can reach the desired cost of equity. For example if the risk free rate in the country reduces it will reduce the cost of capital. As per CAPM model, Cost of equity for an entity = Risk Free Rate + Beta* (Expected Market Return – Risk Free Rate). When this output is plotted against different beta levels, it will provide use the CML line which then can be used for optimization. One can do different levels of sensitivity analysis to determine the actual cost of equity which companies want to achieve. Assumption here is the fact that Government won’t be defaulting on their debt. One can here argue whether it is advisable to make changes to the available rate so that some prudency can be provided to the model. This changes can act as an insulation for the model in case of tough times for the Govt. The companies across the world has used the models extensively to determine the optimized cost of equity under the current scenario. This kind of tools also help in determining whether for capital raising equity should be the way forward in the current scenario or debt. Historically CAPM models have been extensively used by companies to determine the cost of equity and then work out the fair price of the asset by using the same as discounting rate. This is subject to the fact that cost of asset acquisition only involves equity. In case it involves debt one need to do a weighted average of the debt and equity proportion to determine the cost of capital.
Risk Free Rate is generally determined by using the Govt. long term debt papers yield which is considered to be safe proxy for the risk free rate. Assumption here is the fact that Government won’t be defaulting on their debt. One can here argue whether it is advisable to make changes to the available rate so that some prudency can be provided to the model. This changes can act as an insulation for the model in case of tough times for the Govt. The companies across the world has used the models extensively to determine the optimized cost of equity under the current scenario. This kind of tools also help in determining whether for capital raising equity should be the way forward in the current scenario or debt. Historically CAPM models have been extensively used by companies to determine the cost of equity and then work out the fair price of the asset by using the same as discounting rate. This is subject to the fact that cost of asset acquisition only involves equity. In case it involves debt one need to do a weighted average of the debt and equity proportion to determine the cost of capital. CML model helps in optimizing the variables so that company can reach the desired cost of equity. For example if the risk free rate in the country reduces it will reduce the cost of capital. As per CAPM model, Cost of equity for an entity = Risk Free Rate + Beta* (Expected Market Return – Risk Free Rate). When this output is plotted against different beta levels, it will provide use the CML line which then can be used for optimization.
CML model helps in optimizing the variables so that company can reach the desired cost of equity. For example if the risk free rate in the country reduces it will reduce the cost of capital. As per CAPM model, Cost of equity for an entity = Risk Free Rate + Beta* (Expected Market Return – Risk Free Rate). When this output is plotted against different beta levels, it will provide use the CML line which then can be used for optimization. One can do different levels of sensitivity analysis to determine the actual cost of equity which companies want to achieve. Assumption here is the fact that Government won’t be defaulting on their debt. One can here argue whether it is advisable to make changes to the available rate so that some prudency can be provided to the model. This changes can act as an insulation for the model in case of tough times for the Govt. The companies across the world has used the models extensively to determine the optimized cost of equity under the current scenario. This kind of tools also help in determining whether for capital raising equity should be the way forward in the current scenario or debt. Risk Free Rate is generally determined by using the Govt. long term debt papers yield which is considered to be safe proxy for the risk free rate. Assumption here is the fact that Government won’t be defaulting on their debt. One can here argue whether it is advisable to make changes to the available rate so that some prudency can be provided to the model. This changes can act as an insulation for the model in case of tough times for the Govt. The companies across the world has used the models extensively to determine the optimized cost of equity under the current scenario. This kind of tools also help in determining whether for capital raising equity should be the way forward in the current scenario or debt. Historically CAPM models have been extensively used by companies to determine the cost of equity and then work out the fair price of the asset by using the same as discounting rate. This is subject to the fact that cost of asset acquisition only involves equity. In case it involves debt one need to do a weighted average of the debt and equity proportion to determine the cost of capital. CML model helps in optimizing the variables so that company can reach the desired cost of equity.
References:
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