Capital Budgeting Analysis: A Simulation Approach

This assignment content discusses the concept of simulation analysis in capital budgeting, a technique used to analyze investment opportunities by imitating different scenarios and outcomes using random numbers. The process involves identifying variables for cash inflows and outflows, determining probability distributions, and then running multiple simulations to generate a feasibility distribution of potential returns. While simulation analysis is an effective tool for understanding the depth of capital budgeting and improving investment decisions, it has limitations, including being unable to deal with uncertainties and significant inter-relationship scenarios in variables that can lead to wrong consequences and misleading conclusions.

CORPORATE FINANCE MANAGEMENT

An organization is constructed on decisions made by its management. Therefore, the process of
decision making is an important part of an entity, if in any way the decision is stated to be wrong
then the output may not be appropriate and may result in a huge loss to the company in the form
of revenue or reputation. Decision means to reach the conclusion of any scenario only after
examining various fields of action and choosing the most suitable option. The main target of
decision making is to keep up with its goals. Decision making requires constant focus as business
environment is never static. As soon as one problem is eliminated, the second one comes up and
this process continues (Berman, Knight and Case, n.d.)..
The process of corporate decision-making in an entity takes place at different levels, whether
above the bottom or below the top. The implementation of corporate decision-making is made to
be done by its implementers because decisions are only effective when they are being carried out
in the best possible manner (Bruner, Eades and Schill, 2017). Implementing large plans may be
meaningless if no obligation will be presented by middle and lower management. Therefore, it is
very important for the management to maintain a good and healthy relationship with its middle
and lower level of management. Hence, corporate decisions are successful till the point it has the
power to bond which helps the leaders to be encouraged and maintain stability, otherwise, the
institution gets trapped in its own trick which leads to degradation of the competition in the
market (TULSIAN, 2016).
Capital Budgeting refers to the calculation of various expenses or investments, which are huge in
nature. The investment and expenses which need to be calculated contain projects like making of
new plant or long term investments. By capital budgeting, cash inflows and outflows for a
lifetime are being formed so that it can be evaluated to know if the potential return is meeting the
assigned target or benchmark. It is also known as 'investment appraisal'.
For an enterprise, it facilitates the use of all opportunities and projects, but because of the limited
availability of capital at a particular point of time, it forces the management to use capital
budgeting to evaluate the maximum return on all available items at a particular time.
Capital budgeting contains various methods like internal rate of return (IRR), discounted cash
flow (DCF), net present value (NPV) and payback period. They may be defined in the following
manner:
 DCF Analysis: This examination is similar to the NPV analysis because it takes into
account the initial cash outflows which are needed to fund a project, cash inflows and
other future outflows in the form of servicing and other expenses. Such costs have been
discounted to the current date and thus the resulting number is called NPV (Clarke and
Clarke, 1990).

 NPV: It is the distinction between the present value conditions of the cash inflow and the
outflow is used by capital budgeting to determine the profitability of the project or long
term investment.
The positive NVP indicates the expected return after exceeds the cost, and the negative
NPV indicates a financial loss of the firm (Fairhurst, 2015). As an example – A and B are
two different projects with different structures of cash flow and the rate of return
required, and then the NVP of the cash will be as follows:
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
Yea
r 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
Yea
r Cash Flow Present Value of Cash Flows
0 -80000 -80000
1 - -
2 - -
3 - -
4 65000 41,309
5 75000 42,557
NPV 3,866
 Discounted Payback Period:
It is a form of capital budgeting method which specifies the time period of discontinuing

the initial expense by discounting future cash flows and the time value of money.The rule
states that the project will be taken with the discounted payback period offered against
the target period (Taylor, 2008).
 IRR: IRR can be defined as the interest rate at which NVP of all the cash flows is zero for
a given project or long term investment. This can be used to measure the attractiveness of
the investments.
The rule says that if the project is satisfactory, then the IRR of a new project will exceed
the required rate of return fixed by the company (Galbraith, Downey and Kates, 2002).
From the same example that is taken for NPV we are also calculating IRR:
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
80,049
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
80,093
Therefore, at 13.15% Pv of Inflows = PV of Outflows (80,000). Hence IRR is 13.15%

Capital budgeting techniques have the following importance:
 Evaluation of risk: Long-term investment or capital expenditure are costs that are
identifiable and significant financial risks. Hence, capital budgeting is necessary for
perfect planning.
 Choosing of the best course of action: It helps a company to select the perfect investment
project, which will provide top possible returns based on examining each and every
potential course of action. It concentrates on growing the stakeholder's wealth and also
helps the company to gain an edge in the market (Shim and Siegel, 2008).
 Long run of the business: Besides reducing the costs, capital budgeting also helps in
determining company's maximum profits. As it helps in determining the over or under
investments, proper planning and analysis through capital budgeting help to stabilize
business for long run activities…
 Irreversible Investments: It requires huge investments even after the funds being limited.
The firm does not have an option of recovering the fund or decision, so, it is advised to
carefully make a decision on investment of money by analyzing and summarizing all the
possible aspects which may create a problem in near future (Hassani, 2016).
Various types of capital budgeting techniques are present. They are as follows:
 Sensitivity Analysis: It is a type of analysis for determining the results of a decision using
a different range of variables. Analysts define variables in dependable variables due to
the different values of separate variables that constitute certain constant conditions. This
is also called as what if analysis. Any type of decision like family matter or corporate
level decisions may require analysis for proper functioning. In simple words, it means
determining the sensitivity in output because of change in one input keeping other inputs
constant.
The steps for conducting sensitivity analysis are as follows:
 There is a defined base case output; like NPV at some particular point has an input value
(V1) for which sensitivity is to be measured keeping all other input values constant.
 A new value of input helps to find the value of output keeping other input values same.
 After that, the % change in output and input is calculated.
 Dividing the %change in output by the % change in input helps to calculate the
sensitivity.

All the above factors help to conclude by determining that higher the sensitivity figure is, the
more sensitive output is to any change in that respective input and vice-versa.
 Scenario analysis: It is a process of determining the 'expected value' of an investment at a
specific time after considering the specific changes in the factors such as fixed rate,
interest rate, etc.
As a strategy, this type of analysis needs an analyst to count different reinvestment rates
for determining expected profit that is invested again and again in a specific period. This
analysis, in general, determines the difference between the changes in the values of the
portfolio in different situations and it also follows the rule of “What If” analysis. This
assessment is used to determine the potential risk which consists within a given amount
of investment as related to a different variety of potential events, which may have both
high and low probabilities. By this analysis, an investor can determine the amount of risk
he may undertake.
There are many methods to determine it including one of the most common approaches called
standard deviation of monthly or daily security returns and then calculating the expected value of
the portfolio if each savings generate income that are either two or three standard deviations
below or above the average income. In this way, an analyst determines reasonable assurances
about the change in the value of the portfolio in a particular time period (Holland and
Torregrosa, 2008).
It should be noted that the above two analysis are not the same. A better way to understand is to
take an example. For example, an Equity Analyst wants to manage both sensitivity and scenario
analysis to consider the impact of the Earning Per Share (EPS) impact on company's relative
valuation using price to earnings (P / E) multiples.
The valuation of Sensitivity analysis depends on the variables disturbing valuations, which may
be shown by variables' value and EPS. With the help of this analysis, all the possible outcome
ranges are being recorded. On a different note, scenario analysis is implemented by finding the
outcomes based on a scenario (Khan and Jain, 2014). The analysts should try and set a specific
scenario such as changing market conditions or industry regulations. Then he uses different
variables of that same model that matches the scenario. If these things are gathered and
combined, then there is a wide range of outcomes for the analyst to study with all the cases and
different results that are used in different set of real-life perspectives.
 Break Even Analysis: The breakeven point of the company means a point where the
company is making sufficient income to bear all the expenses taking place during that
accounting period. By the definition, if a firm’s net revenue is zero, then there is no profit
and no loss. It is important to mention that the company's debt settlement is not used to
find breakeven points because the lending period is skeptical of the number of return

periods for the initial investment, and the breakeven points are equivalent to revenue and
expenses and total cost with zero net revenue (Saunders and Cornett, 2017). This analysis
shows how much sales we need to pay off the cost of doing business. The following two
points should be considered:
 Accounting breakeven analysis: An accounting breakeven total cost will be equal to the
total revenue because of which the profit tends to be zero. This can be achieved by
calculating the ratio of variable cost to sales. For example, the ratio is 0.65 so that means
the contribution of every rupee of each unit sold is 0.35. Therefore the ratio of
contribution margin is equal to 0.35. Hence, the breakeven point can be calculated using:
BEP = (Fixed Cost + Depreciation) /Contribution Margin Ratio.
If the depreciation is not added by us, the similar BEP is known as cash breakeven point. The
project reached the solution of breakeven point and recognizes that there is zero return. So, only
the invested value may be recovered.
 Financial breakeven analysis: An NPV breakeven takes place when the cash flow is
equivalent to the initial investment which means NPV is zero (Palepu, Healy and Peek,
2016).
So, to reach the breakeven point, analysts have made an analysis of reaching another
level of sales, where the NPV of the project is zero.
 Simulation Analysis: The word 'simulation' implies imitation of a thing or some kind of
action.
Monte Carlo Simulation is a study of imitations of real materials or star of affairs or
many different ways that represent the key feature of a random number using the system
(Phillips, 2014).
It basically adds up the level of dynamic analysis of the capital budget, because it is
created in various different situations that are relevant to the analyst's key assumptions
concerning risk. It considers the probability and interactions of variable variations of the
data. The following steps need to be involved in this type of analysis:
 The variables need to be found out for both cash inflows and outflow (Reilly and Brown,
2012).
 The formula is referred to as associated with all variables and then, for each variable, a
probability distribution will be needed to be determined.

 Now, a computer program will be developed so that one can randomly select a value
from the probability distribution of each and every variable and defines the NPV of the
project using this value.
 The outcome of this is not the result of single-value results, but a feasibility distribution
of all potential returns.
Simulation analysis is an effective tool that may be helpful to understand the depth of the capital
budgeting so that the investment decisions can be improved. It is still unable to deal with the
uncertainties (Saltelli, Chan and Scott, 2008). Also, such an analysis is not a remedy for all
problems, such as significant inter-relationship scenarios in variables can lead to wrong
consequences and misleading conclusions.
Even capital budgeting is so important, still, it has certain limitations in the corporate world.
Some of them are as follows:
 Since it is a long-term perspective, it cannot be used for short-term effects. Also, if
decisions made on the basis of capital budgeting are wrong, then the business may face
adverse effects on the long-term basis of survival in the market. It leads to increase in
operating costs.
 The inadequate and inaccurate investment makes the right budget and right capital
formation difficult.
 Such decisions usually include large amounts, and if decisions are taken, they need to be
carefully crafted as it cannot be changed afterward.

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.