Discussing Capital Budgeting Techniques: Sensitivity, Simulation, Break Even, And Scenario Analysis

Sensitivity Analysis

Question:

Discuss About The Capital Budgeting As It Enables Manager?

Capital budgeting is an important technique used for the purpose of project planning. It involves evaluation of large investments as it requires deployment of huge funds to start a project. The overall profitability of all the alternative plans is considered to make an investment in the project. The risks and the returns on the investments are critically analysed and based on which rankings are allotted to each and every potential project plan. To make an assessment of risks involved in a particular project different techniques can be used such as sensitivity analysis, simulation analysis or the scenario analysis. These techniques are explained below in details.

Sensitivity analysis is also called as “What-If analysis”. This is an important technique used in capital budgeting as it enables the project manager to determine the project’s feasibility if some of the key variables out of the entire set of input parameters such as sales, variable cost, life of the asset, discounting factor etc. gets deviated from the expected value (Gotze, Northcott & Schuster, 2016). In capital budgeting, decisions accounting whether to invest in a particular project plan or not depends upon the Net Present Value of the total cash flows of the project therefore sensitivity analysis is done in NPV terms (Cao & Wan, 2017).The analysis is carried by making a change in one variable while holding the other variables as constant. Technique of sensitivity analysis is widely used by the project managers for the reason that it helps in examining the sensitivity of a project to the changes in input variables (Edmans, Jayaraman & Schneemeier, 2017). Following are some of the key uses of the above explained technique:

• Helpful in making relevant and significant decisions.
• This tool aids to understand the project’s behaviour if there are variations in the key areas.
• It also helps to assess and analyse the risk involved in any business plan or strategy.
• It compels the project manager to identify the key variables which can affect the cash flow level.

• Information not decision: The technique of sensitivity analysis provides the users with the information for capital budgeting decisions but it does not provide the actual decision which managers requires to take( Ross et al., 2010).
• Focus on variables not their probability: Sensitivity analysis only keeps it focus on the key parameters that may get deviated from the expected values but does not determine the probability of occurrence of those variations (Saltelli, 2007).
• Unreasonable assumptions: this analysis is based on the assumption that the key variables are independent of each other, when in actual life they are not.

This method is used to analyse the risk involved in business while making capital budgeting decision with the help of a logical and mathematical model. It uses a series of random but related situations which are possible if there occurs some variations (Baker & English, 2011). Simulation techniques helps in representation of actual decision making under different situations so as to identify the possible courses of action. This tool provides a reasonable method to reach at an appropriate decision while dealing with the real world management situations which are complex enough to be solved. This tool has its own pros and cons which are as follows:

• The simulation technique avoids the rigidity factor as it can adjusted to incorporate several variations in the processes.
• It helps in strategic planning for any business
• The hit and trial runs conducted under this technique avoids the need of experimenting the ideas on new equipment and machineries.
• This technique is easier than the other decision making problems.

• This technique does not provide accurate solutions.
• It is not suitable for all the real business problems.

Simulation does not offer an optimum solution to the concerned problem but it seek to provide the possible range of outputs for the given inputs (Chiarella & Iori, 2002). While using this method the project managers observes the behaviour of the processes experimenting different trial & error runs in the same way as they would observe if they had worked on the real problems (Tavare, 2013).

• Mathematical model: This model uses the numeric values and equations for the representation a real problem. This model has further bifurcations:
• Deterministic Model: This is used when the exact functional relationship between the inputs and outputs is given. This model actually caries the what if analysis.
• Probabilistic Model: this model is also known as stochastic model and is used in the case of random variations (Choe, 2016) (Lima, et al., 2017).
• Physical Model: This model uses physical inputs to test the performance. Like use of prototype model of airplane to determine the characteristics of aerodynamics (Suryani, et al., 2010). This model is expensive enough and therefore need not to be applied to each situation.

Simulation Analysis

The most common method of simulation technique is the Monte Carlo method as it a numerical tool used to determine the results of different inputs for a given situation relating to the business of manager. The inputs are given in the form of series of random numbers with different probabilities of occurrence.

This analysis entails the determination of level of sales a business is required to achieve in order to cover the cost of conducting the business. This analysis is undertaken to make decisions regarding the price fixation of products manufactured by the company. It explains the dynamic relation between the three main factors of any business, i.e. sales, profit and the total cost and hence it is also called as cost-volume-profit analysis (Gutierrez & Dalsted). Breakeven point is the level of sales where the revenues generating from the business meets the total costs of business, leaving the net income as zero.

This is situation where company neither attains any profit nor incurs any losses. The finance manager is mainly concerned about this concept as it is very useful in forecasting of profits of the business and the impact of alternative courses of action in business management (Tsorakidis, 2011).

To conduct the break even analysis break even charts are being used by the management accountants which indicates the relationship of total variable cost, total fixed cost, total cost and the total revenues of the company. There are certain assumptions on the basis of the critical analysis of breakeven point of sales is undertaken. Following are some of those assumptions:

• It does not consider semi variable costs. This analysis assumes only fixed and the variable costs as business costs.
• The product price is assumed to remain same.
• Sales and production volume of the business are assumed to be same.
• It also assumes that the variable cost increases with the production at a constant rate.
• The technology used in production and the efficiency of labour remains constant.

The importance of breakeven analysis is that it offers presentation of every minute picture of the structure of profit of any business. This analysis also aids business managers in keep sharp focus on the leverages which can affect the profitability of business.

• Determination of margin of safety: margin of safety is the level up to which an organisation can accept decline in its sales before it starts making losses. So break even analysis helps the management in determining the level of profit it generates at different level of sales.
• Decision making regarding Make or Buy issues: The analysis assists a firm in deciding whether it will be profitable for it to manufacture a product or to buy it from outside market by identifying the breakeven point.
• Selection of production technique: Breakeven analysis is the simplest way to decide about the deployment of techniques which are most suitable as for lower levels of sales, traditional methods can be used and for higher levels of sales advanced machines may be required. This analysis may help by indicating the costs of alternative production techniques.

• While analysing everything such is kept constant whereas in practical situation it is not so.
• Breakeven analysis ignores the non-financial factors such as changes in the technology, management style improvements etc. as it only considers level of output as the reason for profit.
• Ignorance of taxations in this analysis also makes it unsuitable for the corporates which have higher tax obligations.
• As it is primarily based on accounting data which may not be accurate enough to take decisions so it becomes unreasonable to use this technique.

This analysis is used to estimate the anticipated value of a portfolio of investments at the end of a particular period. As from the above research it can be demonstrated that the sensitivity analysis deals only with the variation of only one parameter at a time to observe the impact on profitability of the company as a result of the change (Kalyebara and Islam, 2014).However, to critically analyse the risk, change in more than one variable must be considered at a time so as to examine the overall behaviour of project’s outcome. Scenario analysis helps in providing the aid to the above issue. This technique basically emphasises on identifying the extent to which the project can turn down in the worst scenarios. Also, it seek to identify the worst and the best case scenarios in order to consider the entire range of possible results (Erdmann & Hilty, 2010). To reach the the worst and best scenarios the analysis starts with the base case. This technique of analysing the scenarios is used to estimate the changes in the value of portfolio as a result of occurrence of unfavourable events. The scenarios that are considered in this analysis can be in relation to a unique variable like a success or failure factor of a project plan or several factors in combination for example project results in combination of changes in the technologies or consumer tastes and preferences (Xuan & Yue, 2017).

• The identification of factors based on which the set-up of scenarios will be made. The factors may vary from firm to firm.
• Determination of number of case scenarios to analyse each factor. In general three scenarios are used which are the best, average and the worst case scenario.
• Placing emphasise on the most critical factors.
• Allocation of probabilities to each and every scenario that was built at the earlier stage.

Break-Even Analysis

Scenario analysis provides the extended solutions to the risk analysis in comparison to the sensitivity analysis. Rather than considering the sensitivity of a project to the variability of input parameters, the scenario analysis also focuses on the distribution of probability to different variables. These probabilities are allocated to the scenarios to calculate the expected value.

Conclusion

From the above research it can be concluded that all the capital budgeting techniques possess their own advantages but still suffers some limitations which makes them unreasonable to be applied by the project managers in certain situations. A project manager needs to apply requisite skills and knowledge to conduct the analysis under the above explained techniques. As these techniques of capital budgeting does not provide the managers with the firm decision they are required to interpret the information provided by the analyses. However, the case of breakeven analysis is slightly different as it provides the exact results the company must achieve in order to cover the total costs. Breakeven charts are also easy to interpret the desirable targets which are to be achie

References:

Baker, H. and English, P., 2011. Capital Budgeting Valuation. Somerset: Wiley.

Cao, X.R. and Wan, X., 2017. Sensitivity analysis of nonlinear behavior with distorted probability. management Finance, 27(1), pp.115-150.

Chiarella, C. and Iori, G., 2002. A simulation analysis of the microstructure of double auction markets*. Quantitative finance, 2(5), pp.346-353.

Choe, G. H., 2016, Stochastic Analysis for Finance with Simulations, Springer International Publishing, Switzerland.

De Lima, J.D., Trentin, M.G., Oliveira, G.A., Batistus, D.R. and Setti, D., 2017. Systematic Analysis of Economic Viability with Stochastic Approach: A Proposal for Investment. In Engineering Systems and Networks (pp. 317-325). Springer, Cham.

Edmans, A., Jayaraman, S. and Schneemeier, J., 2017. The source of information in prices and investment-price sensitivity. Journal of Financial Economics.

Erdmann, L. and Hilty, L.M., 2010. Scenario analysis. Journal of Industrial Ecology, 14(5), pp.826-843.

Gotze, U., Northcott, D. and Schuster, P., 2016. INVESTMENT APPRAISAL. Springer International Publishing, Berlin.

Gutierrez. P. & Dalsted, N., n.d, Break-Even Method of Investment Analysis, Colorado State University, available at < https://extension.colostate.edu/docs/pubs/farmmgt/03759.pdf > (viewed on 15-09-2017).

Kalyebara, B. and Islam, S., 2014. Corporate Governance, capital marketing, and capital budgeting. Dordrecht: Physica-Verlag.

 Ross, S., Traylor, R., Bird, R., Westerfield, R. & Jordan, B., 2010. Essentials of corporate finance, edn 2^nd, McGraw-Hill Education.

Saltelli, A. 2007, Sensitivity analysis in practice. Chichester: John Wwiley and Sons.

Suryani, E., Chou, S.Y., Hartono, R. and Chen, C.H., 2010. Demand scenario analysis and planned capacity expansion: A system dynamics framework. Simulation Modelling Practice and Theory, 18(6), pp.732-751.

Tavare, N.S., 2013. Industrial crystallization: process simulation analysis and design. Springer Science & Business Media.

Tsorakidis, N., Papadoulos, S., Zerres, M. and Zerres, C., 2011. Break-Even Analysis. Bookboon.

Xuan, Y. and Yue, Q., 2017. Scenario analysis on resource and environmental benefits of imported steel scrap for China’s steel industry. Resources, Conservation and Recycling, 120, pp.186-198