Capital Budgeting: Sensitivity, Scenario, Break-even and Simulation Analysis

Capital Budgeting 1
Capital Budgeting

Capital Budgeting 2
Contents
Overview:...................................................................................................................................3
a. Sensitivity analysis.................................................................................................................3
b. Scenario analysis....................................................................................................................5
c. Break-even analysis................................................................................................................6
d. Simulation analysis................................................................................................................7
Conclusion..................................................................................................................................9
References................................................................................................................................10

Capital Budgeting 3
Overview:
Capital Budgeting is a process that a business undergoes, to evaluate the upcoming projects
and investments. This process is set into practice to assess, whether, the upcoming project or
investment will be able to generate expected returns through various ways like throughput,
payback analysis and discounted cash flow. While evaluating, a business may consider the
cash inflow and outflow of the potential project or investment. This practice is also known as
Investment Appraisal. (Hayward, Caldwell, Steen, J., et.al, 2017)
In Capital Budgeting Analysis, the first and foremost step is to identify the opportunity and
then followed by analyzing the opportunity which takes into account various criteria to judge
the purposefulness of a project. Since, any business has limited resources, capital and time,
the capacity to take up projects or investments is also limited. To utilize their limited
resources, capital and time, businesses must choose the most beneficial investment plan
(Malenko, 2018). Hence, businesses evaluate the prospective projects through Capital
Budgeting and opt for the plan that promises them best returns over its lifetime.
a. Sensitivity analysis
Sensitivity analysis in Capital Budgeting Analysis is a method to determine the returns of a
potential project or upcoming investment by focusing on the variables. It forecasts the risk
that may be faced by the business in the future upon accepting a project (de Andrés de
Fuente, and San Martín, 2015). It considers individual input factors and foretells the outputs.
By changing the input determinants like sales revenue, competition, input revenue, etc.
Sensitivity Analysis tells what effects it will have on the outcome of the project (Marchioni,
and Magni, 2018). It assumes or predicts the unexpected factors before actually starting the
project and facing them. The sensitivity of a capital budgeting proposal can be determined by

Capital Budgeting 4
factors like level of revenues, the margin for operations, ratio of working capital requirements
to revenue and expected growth rate.
The purpose of Sensitivity Analysis in Capital Budgeting is to identify the effects on the NPV
of a proposal after subjecting to various changes in variables. It foretells the sensitivity or
vulnerability of an investment. Businesses that operate in turbulent markets have tough
competition, many rivals, variable sales, and other unexpected ups and downs must check the
sensitivity analysis of their capital budgeting proposals. It will help them predict the range of
fluctuation in the variables that are optimal for their business (Kengatharan, 2016). Also, it
will help to identify the most vulnerable factor that the business must keep a check while
executing the project.
A sensitivity analysis in capital budgeting is a useful method to check for weak spots in the
investment. The best kind of knowledge a business can possess is self-awareness. Knowing
own weak spots can not only help cease the universal problem of 'what are we doing wrong?'
but also help in allocating resources and monitors at the right places. Knowing about own
weaker areas will aid the management to critically evaluate every plan concerning its
usefulness to the respective aspects.
However, a sensitivity analysis works by varying a determinant and keeping others constant.
For instance, changes in price and sales go hand in hand and keeping one variable and
another constant for calculation sake will not gain real-time projections. Moreover, the
projections or results hence gained are evaluated based on experience and trends which may
not hold in the present since the market is a dynamic platform where the taste of the
consumer to the fiscal policies changes frequently. Post these negligence’s, sensitivity
analysis in capital budgeting is only a risk predicting method, not a risk-reducing method
which reduces its credibility significantly.