Financial Modeling Fundamentals: Understanding Corporate Decision Making And Capital Budgeting

Capital Budgeting

Discuss About The Business Of Financial Modeling Fundamental?

Decision – making is a part of our daily lives. For any human – being, its a daily activity and there is no exception to that. For a business entity, decision making is a habit and a process as well. A ‘decision’ is referred to as the course of action chosen among a set of alternative actions so as to achieve the organizational goals. Decision making is an ongoing process and indispensable component for management of organizational activities (Berman, Knight and Case, n.d.).

Corporate decision making takes place at various levels of the entity and can either be top-down or bottom-up. The top down decisions are made by the top management and the decisions are passed on down the corporate ladder for the implementation purpose. On the other hand, the bottom up decisions are taken by the middle & line managers based on the conditions & circumstances existing in the internal environment of the firm. What is always noticed is that the top level decisions are related to policies, strategies, focus & directions while bottom level decisions are related to day-to-day operations.

The middle management is often referred to as the ‘sandwich’ layer because they are responsible for implementing the decisions made and have to accordingly decide the process of running their teams as well as communicate it to the lower level workers. The point to he stated over here is that in any process of corporate decisions, the critical role is being played by the actual implementors since even the best profitable plan can lead a firm nowhere if there is no commitment from the middle management (Bruner, Eades and Schill, 2017). Hence, alot of organizations organize off site meetings at resorts or hotels and briefs the management about the decisions taken and the impact of such decisions on the organization.

Corporate decision making is successful as long as there is a glue to keep the organization together in the form of encouraged leaders or an organizational culture that values stability and coherence. Once any of these conditions are lost, the firm falls in its own trap and this leads to loss of competitiveness of the company (TULSIAN, 2016).

Capital budgeting is the process by which the business analyzes the large amount of investments & expenses that are large enough to affect an organization’s future. Usually, these investments include projects such as building a new plant or purchase of heavy machinery. In this case, a project’s cash inflows & outflows are being assessed so as to determine whether the returns that are being generated meet the required benchmark or not. This is also known as ‘Investment Appraisal’. For a business, it is advantageous to take up all the opportunities & projects but due to the limitation of capital at that point of time, capital budgeting techniques are being used so as to analyze the maximum returns from all the avaliable projects at that point of time and thereby, choosing the best course of finance. Various tools of capital budgeting involves NPV, IRR, discounted payback period, etc (Clarke and Clarke, 1990).

Year	A	B
0	-80000	-80000
1	20000	–
2	24000	–
3	20000	–
4	27000	65000
5	30000	75000

Required rate of Return 12%
NPV of Project A
Year	Cash Flow	Present Value of Cash Flows
0	-80000	-80,000
1	20000	17,857
2	24000	19,133
3	20000	14,236
4	27000	17,159
5	30000	17,023
	NPV	5,407
NPV of Project B
Year	Cash Flow	Present Value of Cash Flows
0	-80000	-80000
1	–	–
2	–	–
3	–	–
4	65000	41,309
5	75000	42,557
	NPV	3,866

Calculation of Internal Rate of Return of each project
For Project A:
For Calculation of IRR, Inflow=Outflow
Let be IRR 14.50% then
PV of Inflows
Year	Cash Flow	Present Value of Cash Flows
1	20000	17,467
2	24000	18,306
3	20000	13,323
4	27000	15,709
5	30000	15,244
Therefore, at 14.50% Pv of Inflows = PV of Outflows (80,000). Hence IRR is 14.50%
For Project B:
For Calculation of IRR, Inflow=Outflow
Let be IRR 13.15% then
PV of Inflows
Year	Cash Flow	Present Value of Cash Flows
1	–	–
2	–	–
3	–	–
4	65000	39,655
5	75000	40,438
Therefore, at 13.15% Pv of Inflows = PV of Outflows (80,000). Hence IRR is 13.15%

Example on NPV and IRR

Sensitivity analysis- Sensitivity analysis is the tool which helps to determine the effect of change of independent factor on the dependent factors given different situations and assumptions. It is used keeping in mind certain limitations which are dependent on the input factors. One of the most common examples of sensitivity analysis is effect of changes in market interest rates on securities. The technique of sensitivity analysis helps to measure the responsiveness of one factor based on change in other. It helps to analyse the effect of decision making on one or more inputs. This helps to understand the behaviour of the factors by changing the model (Taylor, 2008).

Given a situation, we have Mr. A, who is a sales manager of a store; he wants to comprehend the effect of increase in customer base on the operating revenue. Based on findings and research Mr. A came to a conclusion that the sales are directly related to volume and product pricing, creating a function between all these factors.  The product price was $50 per unit, and the sales volume achieved last year by Mr. A was 10,000 units, earning himself total revenue of $500000. Doing a little more study, Mr. A found out that an increase in customer base by 10 percent would help him increase the revenue by 3 percent. This whole situation is a great example of sensitivity analysis, of how on independent variable would affect a dependent one in the given scenario. With the help of available information, Mr. A can now calculate the expected increase in revenue by estimating the increase in customer base (Galbraith, Downey and Kates, 2002).

The technique of sensitivity analysis helps to analyse the affect of various variables on the outcome of the project. This help the investor understand the effect of change in cash flows, interest rates and other variables on the outcome of the project. Capital budgeting is the way which helps the investor understands the viability of a given project. Sensitivity analysis helps them understand the volatility of change in outcome whenever any input variable is changed.  Sensitivity analysis helps us understand the effect of change in one estimate or one assumption on the entire outcome of the capital budgeting technique. Therefore, we can say that sensitivity analysis helps double check the results of capital budgeting given different situations and assumptions (Shim and Siegel, 2008).

Scenario Analysis : This analysis is a process of analyzing decisions by considering all the possible outcomes and is designed in such a way so as to see the consequences of an action under different set of factors. It involves determining the ‘expected value’ of an investment assuming specific changes in the key factors such as interest rates, etc after a particular period of time. For example, the difference in the investment’s NPV due to variations in inflation. This is basically a ‘what-if’ analysis and determines the changes in the value of the portfolio based on happening of different scenarios. Scenarios created should be feasible enough to provide an accurate picture of the possible outcomes (Hassani, 2016). Basically, an analyst is required to determine the level of risk present within an investment.

Various Capital Budgeting Techniques

The most common approach out of various approcahes is called standard deviation of monthly or daily security returns and then, computation of the expected value of the portfolio if each security shows returns that are above or below the average returns by being two or three standard deviations. An analyst is required to assess the reasonable certainty at a particular period of time concerning the changes in the value of a portfolio.

Now,it is important to distinguish scenario analysis from sensitivity analysis as often, these two are considered to be more or less same (Holland and Torregrosa, 2008). However, there is a sharp difference between both of them. Considering an example, suppose an equity analyst wants to analyze the effect of earnings per share (EPS) on company’s valuation by using price to earnings (P/E) multiple technique and therefore, is required to conduct both sensitivity & scenario analysis.

Here, while conducting sensitivity analysis, variable price & EPS affecting the valuation will be determined and then, all the possible outcomes are being recorded. However, when conducting scenario analysis, different outcomes are to be formed based on an scenario. For example, an analyst has to determine a certain scenario such as marketing crash or changes in regulations of the industry. Based on that, he uses different variables to suit that scenario. Keeping all these factors at one place, the analyst would be acquainted with range of outcomes, given all extremes and a clear picture of different outputs based on different set of inputs characterized by real life scenarios (Khan and Jain, 2014).

Break Even Analysis : This analysis involves the determination of a point where the company’s net income would be zero, that is, there is no profit & no loss. This point refers to as ‘breakeven point’. By definition, the company determines a point where it is generating enough revenue so as ti cover all the expenses incurred during an accounting period (Saltelli, Chan and Scott, 2008). It is to be stated over here that breakeven analysis is different from payback period as payback period is used to find the period in which the initial investment is to be paid back, while breakeven analysis is concerned with equalling of revenue and total costs with zero net income. This analysis analyzes the number of sales required to pay off the costs of doing that business. Now breakeven analysis involves two concepts where one is being viewed from accounting perspective and one from financial perspective (Saunders and Cornett, 2017).

Financial breakeven analysis : An NPV breakeven occurs when the initial investments gets equal to the cash flows and NPV turns out to be zero. Thus, to determine a breakeven point, an analyst has to determine that level of sales where the NPV of the project comes out to be zero.

Accounting breakeven analysis : Here, the breakeven happens when the total revenue equals total cost and there is neither loss nor income. This can be reached by computing the variable costs to sales ratio. For example, the ratio comes out to be 0.80, that means with every rupee of a sales of each unit, contribution is 0.20. Thus, the contribution margin ratio comes out as 0.20. And therefore, the breakeven point is calculated by (Palepu, Healy and Peek, 2016) :

Simulation Analysis : The term ‘Simulation’ refers to pretending of some action or more precisely, imitation. It makes use of statistical data so as to figure out the average outcome of a scenario based on complex & multiple factors. The statistical distribution is being estimated for each input and simulation analysis is done to see the effect of changing inputs on the output. It is a dynamic analysis that considers the probabilities of changes or interactions among possible variables. This is used in various areas of business such as bond pricing (Phillips, 2014). It is designed in such a way to see the impact on the outcome on an average when there are possible changes in the inputs. Each potential factor is assigned a statistical or probability distribution that could change the results of an investment. For example, the default on bonds is being estimated to be 20%.

Simulation analysis is useful for in depth understanding of the capital budgeting for enhancing the investment decisions.  However, it is not able to handle uncertainties. Also, it aint a good remedy of all problems as significant inter relationships between different variables, if overlooked, would lead to misleading information’s & wrong results and decisions (Reilly and Brown, 2012).

Conclusion

This assignment has made me learn and know the importance of capital budgeting and its various techniques which are discussed here. Evaluation of risks, long term investments involves high considerable risk and are capital expenditures. This investments are huge in nature and therefore, once the decision is being made or amount is being invested, it is irreversible in nature. Therefore, capital budgeting is being used for proper planning. Choosing of Best course of action, capital budgeting helps a company to choose the best course of action that would yield the best possible returns (Fairhurst, 2015). Its main concern is to increase the shareholder’s wealth and helps a company in achieving an edge in the market. Sustainability or Long Run of the business, capital budgeting believes in optimum results, that is, best maximum profits with minimum costs and best utilization of resources. Thus, it helps in avoiding under or over investments and thereby, helping in sustainability of an entity in a long run perspective.

References

Berman, K., Knight, J. and Case, J. (n.d.). Financial intelligence for HR professionals.

Bruner, R., Eades, K. and Schill, M. (2017). Case studies in finance. Dubuque, IA: McGraw-Hill Education.

Clarke, R. and Clarke, R. (1990). Strategic financial management. Homewood, Ill.: R.D. Irwin.

Fairhurst, D. (2015). Using Excel for Business Analysis A Guide to Financial Modelling Fundamenta. John Wiley & Sons.

Galbraith, J., Downey, D. and Kates, A. (2002). Designing dynamic organizations. New York: AMACOM.

Hassani, B. (2016). Scenario analysis in risk management. Cham: Springer International Publishing.

Holland, J. and Torregrosa, D. (2008). Capital budgeting. [Washington, D.C.]: Congress of the U.S., Congressional Budget Office.

Khan, M. and Jain, P. (2014). Financial management. New Delhi: McGraw Hill Education.

Palepu, K., Healy, P. and Peek, E. (2016). Business analysis and valuation. Andover, Hampshire, United Kingdom: Cengage Learning EMEA.

Phillips, J. (2014). Capm / pmp. New York: McGraw Hill.

Reilly, F. and Brown, K. (2012). Investment analysis & portfolio management. Mason, OH: South-Western Cengage Learning.

Saltelli, A., Chan, K. and Scott, E. (2008). Sensitivity analysis. Chichester: John Wiley & Sons, Ltd.

Saunders, A. and Cornett, M. (2017). Financial institutions management. New York: McGraw-Hill Education.

Shim, J. and Siegel, J. (2008). Financial management. Hauppauge, N.Y.: Barron’s Educational Series.

Taylor, S. (2008). Modelling financial time series. New Jersey: World Scientific.

TULSIAN, B. (2016). TULSIAN’S FINANCIAL MANAGEMENT FOR CA-IPC (GROUP-I). [S.l.]: S CHAND & CO LTD.