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Capital Budgeting Techniques Assignment

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Added on  2020-04-01

Capital Budgeting Techniques Assignment

   Added on 2020-04-01

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Capital Budgeting techniques1
Capital Budgeting Techniques Assignment_1
ContentsIntroduction......................................................................................................................................3Net Present Value and Internal rate of return..................................................................................3Discussion of all the four analysis techniques that impacts the results under NPV and IRR..........5Sensitivity Analysis.........................................................................................................................5Scenario analysis...........................................................................................................................11Simulation Analysis.......................................................................................................................13Break Even analysis.......................................................................................................................13Conclusion.....................................................................................................................................14References......................................................................................................................................152
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IntroductionManagement decision making is the most complex process that involves project selectionin order to accomplish the organization goals. Project selection means selecting the best optionfrom the available choice of projects. Capital budgeting is the process that helps the managers toanalyze the projects on the various grounds such as their profitability, risk and uncertainty.Capital budgeting decisions can be taken to accomplish the requirement of working capital andalso to acquire the fixed assets. Other than project selection can also be done using thetechniques provided in the capital budgeting. The process of capital budgeting is truly based oncost benefit analysis and cash flow generated by the project. So it can be said that there is noarbitrary method of selection under capital budgeting decisions. There are various methodsavailable to analyze the projects but net present value (NPV) and internal rate of return (IRR) arewidely used due to their precise decision making capacity (Otley and Emmanuel, 2013). The net present value and internal rate of return can further be analyzed using themethods such as sensitivity analysis, scenario analysis, breakeven analysis and simulationanalysis. The purpose of report is to check role that capital budgeting decisions play whileperforming the managerial process. So, NPV and IRR method will be analyzed in detail on theground of all the four analysis techniques. Net Present Value and Internal rate of returnIn order to better understand the techniques of capital budgeting it is essential tounderstand the concept of NPV and IRR. Both these methods are impacted by all four techniquesnamely sensitivity analysis, scenario analysis, breakeven analysis and simulation analysis. 3
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Net present value is based on the amount of initial investment made and amount of cashflows generated by the project in future. The future cash flows are discounted using the timevalue and converted into the present value to compare with initial investment. Investments areusually made at initial stage in form of fixed assets and at later stage in the form of workingcapital. Cash inflows are dependent upon the future expected incomes and expenses occurred toearn that income. It can be said that expected sales income depends on the sales volume andmarket size. It can be concluded from the above information that NPV is impacted with thechange of variables like expected revenue, cost, sales volume and market size. These variablescan be divided in micro and macro level i.e. variables that changes due to internal companypolicies and variables that change due to impact of external conditions. Cost of the project caninclude initial investment (mainly treated as depreciation over the life of project), variable costand fixed cost that occur every year (Baker, 2011). The NPV and IRR methods usually use cashoutflows and inflows, and cost of capital i.e. discount rate to analyze the projects. So thevariables that change these values will also change the values during the analyses. In thesensitivity analysis there can be three main cases such as, pessimistic (Worst Case), expectedcase and Optimistic (Best Case). The analysis technique used to calculate the change in NPV andIRR under all three cases is called as sensitivity analysis (Otley and Emmanuel, 2013).Net present Value: Net present value is calculated as present value of cash inflows less presentvalues of cash outflows. Time value methods are used to calculate the present value of cashinflows and cash outflows. Net present value means the profit the project will provide at thepresent time if project is selected today. Positive value of NPV means that project will generatethe income and negative NPV means the project will generate loss if chosen. 4
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