Capital budgeting
Management has the power of decision-making in its hand which gives it really important status in a firm. Let it be a major decision or a minor decision, it is necessary for the management to analyze the problem and make decisions in order to eliminate it. Any wrong decision by the management will result in direct impact on the working of a company (Berman, Knight and Case, n.d.). The wrong decisions will not only harm the firm in financial aspects but also it will harm the reputation and status of the firm in the market which will make it difficult for the firm to survive in the long run.
Decisions are made for every position on the level of the organization, that is, the top level, intermediate level, and the lower level. It is really important for the firm to accept the decisions of the management as it is very difficult to make decisions because the task of decision-making is very complex (Bruner, Eades and Schill, 2017). In order to attain proper functioning of the firm, there should be a sound relationship present between the management and the firm’s employees. Capital budgeting is implemented by the management for making financial decisions in a better manner so as to ascertain that no loss is suffered by the firm in near future.
Capital budgeting is the process of analyzing and evaluating all the expenses and investments of the firm having huge amounts. There are certain examples which may help us to understand the transactions which come under capital budgeting like, manufacturing of a plant and machinery or investment in some long-term assets. This process takes into account current cash outflows at present and future cash inflows to checks whether if the company is in the state of earning the required rate of return. Therefore it is also called as “investment appraisal method” (Clarke and Clarke, 1990).
As mentioned above that capital budgeting is a wide scope, there are several methods included in it. The most important methods are the Net present values (NPV) and internal rate of return (IRR). They may be explained as follows:
- NPV: Net present value is evaluated by computing the difference between a number of cash outflows and a number of cash inflows. This formula makes it easier to identify the method of capital budgeting which can be used to know about the profits or loss incurred and if gained or lost anything then what is the accurate value. A positive NVP is considered to be better than the negative NPV which is considered to be unfavorable (Fairhurst, 2015).
- IRR- The internal rate of return (IRR) may be used to evaluate if the asset in which the company is going to invest is favorable for its profit or not. If there is a case where all the net present value of all cash flows is zero, then the interest rate is called IRR. It is said to be advantageous when the IRR is greater than the required rate of return and is disadvantageous when the IRR is less than the required rate of return.
- The given example will help us to examine and understand the concept of IRR and NPV in a much better way. The cash flows of two different projects are shown below:
All these methods were involved in order to perform the process of capital budgeting. There are several different techniques of capital budgeting termed as Sensitivity analysis, Scenario analysis, Breakeven analysis and Simulation analysis (Galbraith, Downey and Kates, 2002).
There are a lot of variables present; some of them are independent while others are dependent on each other. Sensitivity analysis helps in analyzing the possible outcomes by using these variables. After keeping some of the conditions unchanged, the changes in the dependent variable caused due to changes in independent variables are evaluated by the analyst. Sensitivity analysis may also be called as “What if analysis”. It is important to analyze even the smallest of problems because it may cause a problem in future. Hence, we now know that how important is it to take corporate decisions only after proper analysis. The name in itself says that even a small variation in the inputs will be affecting the output when other factors are kept unchanged (Hassani, 2016).
Sensitivity Analysis
There are several steps that are needed to be carried out in order to perform sensitivity analysis:
- There is supposed to be a base unit which will be used to compute the sensitivity of the given data keeping other things unchanged.
- It also helps to find the output value when all other values are kept unchanged except the new level of output (Holland and Torregrosa, 2008).
- The percentage change in income and output are required for the analysis.
- Sensitivity analysis may be carried out by the formula- percentage change in output by the percentage change in input.
From the above-mentioned steps it is clear that the higher the value of percentage change will be, the more sensitivity figure will increase. Also, if the output is kept unchanged and the value of percentage change in input decreases then also there will be a rise observed in the value of the sensitivity figure (Khan and Jain, 2014).
This type of analysis helps to determine the “expected value” that may be received by an investment in the future after a fixed time period when certain factors like the interest rate which is changed (Palepu, Healy and Peek, 2016). It is an important task for the analyst to compare all the investments present and choose the best alternative for its client so that it may help him earn revenue in future. The market is dynamic in nature, so the returns on the portfolios are never constant and change from time to time and thus this analysis helps in computing the extent of changes. The investment is having a volatile nature which can be of high or low risk. This analysis is thus helpful in determining the amount of risk factor a firm or a company is ready to face (Phillips, 2014).
The standard deviation is calculated to know the level of risk and it is also taken as the variable which may be used to compute the risk. The means of variables are used to calculate the expected returns. Also, the possibility of changes in the portfolio may be computed using this analysis (Reilly and Brown, 2012). There is a huge difference between the sensitivity and scenario analysis which should be cleared before any calculation. Also, it should be noted that the variables affect the computation of analysis in this case of sensitivity analysis.
The main motive of every firm is to recover the cost and then incur profits. The situation where the total cost of the firm equals total profit and the net income is valued zero is said to be the breakeven point. According to financial aspects, it may be said that net income of the company will be zero(Saltelli, Chan and Scott, 2008). A low breakeven point is good for the company because it means that the company will incur good and timely profits. Sometimes confusion between breakeven point and payback point arises. It should be cleared that payback point is the time period in which the initial investment is to be returned whereas breakeven point is not dependent on time but dependent on the amount of sales or units.
It can be further divided into two sub-categories:
- Accounting Breakeven Analysis: the equation to define breakeven analysis is – Total Revenue=Total Cost. It may be computed on the basis of the volume of sales or in terms of units. The formula for the breakeven point is as follows:
Breakeven Point = (Fixed Cost + Depreciation) /Contribution Margin Ratio.
If depreciation will be excluded from the point then the result is known as cash breakeven point (Saunders and Cornett, 2017) .
- Financial Breakeven analysis: It is the point where the net present value of analysis is zero and in such a case the cash flow is also at par with the initial investment.
Simulation means to imitate or pretend some action. This type of analysis is done in order to compute the chances and meeting of different variables of a group. This action is considered to be an important part of the capital budgeting process as it helps to find certain results which help to make decisions regarding the investments (Shim and Siegel, 2008). There are also few limitations which make it a bit hazardous like if we ignore some of the variables then the whole analysis will become rouge and thus result in providing wrong information to the analyst.
These are several steps involved in this type of analysis:
- Finding certain values or variable that affect the cash flows directly or indirectly.
- Formulas for both simulation analysis and profitability distribution are stated together.
- The distribution made is taken as a sample and the computer program chooses a random variable and with the help of the variable net present value of the firm may be determined n this step.
- It will be observed that there is not a single value but there is a whole profitability distribution as the result which shows all the expected and possible returns of the firm.
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.
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