Capital Budgeting Management Doc

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Added on  2020-03-23

Capital Budgeting Management Doc

   Added on 2020-03-23

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Capital budgetingManagement has the power of decision-making in its hand which gives it really important statusin a firm. Let it be a major decision or a minor decision, it is necessary for the management toanalyze the problem and make decisions in order to eliminate it. Any wrong decision by themanagement will result in direct impact on the working of a company (Berman, Knight andCase, n.d.). The wrong decisions will not only harm the firm in financial aspects but also it willharm the reputation and status of the firm in the market which will make it difficult for the firmto 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 decisionsof the management as it is very difficult to make decisions because the task of decision-makingis very complex (Bruner, Eades and Schill, 2017). In order to attain proper functioning of thefirm, there should be a sound relationship present between the management and the firm’semployees. Capital budgeting is implemented by the management for making financial decisionsin 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 ofthe firm having huge amounts. There are certain examples which may help us to understand thetransactions which come under capital budgeting like, manufacturing of a plant and machinery orinvestment in some long-term assets. This process takes into account current cash outflows atpresent and future cash inflows to checks whether if the company is in the state of earning therequired rate of return. Therefore it is also called as “investment appraisal method” (Clarke andClarke, 1990).As mentioned above that capital budgeting is a wide scope, there are several methods included init. The most important methods are the Net present values (NPV) and internal rate of return(IRR). They may be explained as follows:1.NPV: Net present value is evaluated by computing the difference between a number ofcash outflows and a number of cash inflows. This formula makes it easier to identifythe method of capital budgeting which can be used to know about the profits or lossincurred and if gained or lost anything then what is the accurate value. A positiveNVP is considered to be better than the negative NPV which is considered to beunfavorable (Fairhurst, 2015).2.IRR- The internal rate of return (IRR) may be used to evaluate if the asset in which thecompany is going to invest is favorable for its profit or not. If there is a case where allthe net present value of all cash flows is zero, then the interest rate is called IRR. It issaid to be advantageous when the IRR is greater than the required rate of return and isdisadvantageous when the IRR is less than the required rate of return.
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3.The given example will help us to examine and understand the concept of IRR andNPV 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 areseveral different techniques of capital budgeting termed as Sensitivity analysis, Scenarioanalysis, Breakeven analysis and Simulation analysis (Galbraith, Downey and Kates, 2002).Sensitivity Analysis:There are a lot of variables present; some of them are independent while others are dependent oneach other. Sensitivity analysis helps in analyzing the possible outcomes by using thesevariables. After keeping some of the conditions unchanged, the changes in the dependentvariable caused due to changes in independent variables are evaluated by the analyst. Sensitivityanalysis may also be called as “What if analysis”. It is important to analyze even the smallest ofproblems because it may cause a problem in future. Hence, we now know that how important isit to take corporate decisions only after proper analysis. The name in itself says that even a smallvariation in the inputs will be affecting the output when other factors are kept unchanged(Hassani, 2016). There are several steps that are needed to be carried out in order to perform sensitivity analysis:1.There is supposed to be a base unit which will be used to compute the sensitivity of thegiven data keeping other things unchanged.2.It also helps to find the output value when all other values are kept unchanged except thenew level of output (Holland and Torregrosa, 2008).3.The percentage change in income and output are required for the analysis.4.Sensitivity analysis may be carried out by the formula- percentage change in output bythe 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 ofpercentage change in input decreases then also there will be a rise observed in the value of thesensitivity figure (Khan and Jain, 2014).Scenario Analysis:This type of analysis helps to determine the “expected value” that may be received by aninvestment in the future after a fixed time period when certain factors like the interest rate whichis changed (Palepu, Healy and Peek, 2016). It is an important task for the analyst to compare allthe investments present and choose the best alternative for its client so that it may help him earnrevenue in future. The market is dynamic in nature, so the returns on the portfolios are neverconstant and change from time to time and thus this analysis helps in computing the extent ofchanges. The investment is having a volatile nature which can be of high or low risk. This
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