Capital Budgeting Techniques: Sensitivity, Breakeven, Scenario and Simulation Analysis

This article discusses the different capital budgeting techniques like sensitivity analysis, breakeven analysis, scenario analysis, and simulation analysis. It explains their importance, limitations, and applications in making capital budgeting decisions. The article also provides a brief overview of capital budgeting and its purpose.

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Table of Contents
Overview.....................................................................................................................................................3
Sensitivity Analysis.....................................................................................................................................3
Importance of Sensitivity Analysis..........................................................................................................4
Limitations of Sensitivity analysis...........................................................................................................4
Break-even Analysis....................................................................................................................................5
Importance of Breakeven analysis in capital budgeting decisions...........................................................5
Calculation of Breakeven cases...............................................................................................................6
Limitations of Breakeven analysis...........................................................................................................6
Scenario Analysis........................................................................................................................................7
Importance of Scenario Analysis.............................................................................................................7
Limitations of Scenario Analysis.............................................................................................................8
Simulation Analysis....................................................................................................................................8
Importance of Simulation Analysis.........................................................................................................9
Limitation of Simulation analysis................................................................................................................9
Conclusion.................................................................................................................................................10
References.................................................................................................................................................11

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Overview
Capital budgeting is a statistical technique to determine the cost and benefits relating to the
investment in the project. This process is also known as investment appraisal. This process helps
in determining the risk associated with the investment (Hayward, Caldwell, Steen, Gow and
Liesch, 2017).
There are different methods of capital budgeting to assessing the feasibility of a project like
Payback period, Average rate of return (ARR), Net present value (NPV), etc. These techniques
are constantly used in the various regions and analysis such as sensitivity analysis, breakeven
analysis, scenario analysis, and simulation analysis.
The major purpose of budgeting is to make the projections of the revenue and the expenses. To
consider the model of how the business performs at the financial front. It allows the actual
business operations to be compared against the forecast and it also creates the restriction o the
costs for a particular project, program, and operations. Moreover, the most important aid that is
presented by the budgeting is facilitating the managers to apply those techniques in the
conditions that might see a change as well (Iooss and Lemaître, 2015).
It also encourages managers to consider problems before they arise. It also helps to co-ordinate
the operations of the firms by compelling managers to investigate the relationships between their
as well as the other departments.
Sensitivity Analysis
Sensitivity analysis is an analytical technique that helps in finding out the deviation that occurs
from the expected value. It determines the amount by which the data of input can be changed for

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the change in output. It is a statistical technique in which the parameter and inputs are connected
through algorithms to make output. The output tells the manager whether the project would reap
profits or not which helps them to assess risk and find out the level of returns in a project while
making capital budgeting decisions. Sensitivity analysis is a core methodology for forecasting
and addressing the issues to the management. It is kind of a critical variable and it also displays
the range of analysis that is beneficial before finally accepting the projecting. It certainly is not
measuring the risks on a direct basis; however, it is understood by the change in the only one
variable by keeping the other variable constant (VanderWeele and Ding, 2017).
Importance of Sensitivity Analysis
 Recommendation for decision making: Sensitivity index through the parameters and
algorithms helps in testing the robustness of the project which provides support in
decision making and recommends whether the project should be chosen or not.
 Makes a clear understanding of the system: By understanding the relationship between
the input and output between variables and their changes in the response of each other
helps in giving vivid quantification of the system (Borgonovo and Plischke, 2016).
 Development of model: As sensitivity index enhances the communication by making
more credible recommendations and finding out errors in the model. It constantly
develops the model which gives a better picture of capital budgeting through net present
value.
Limitations of Sensitivity analysis
 There are variables which are often interdependent and this creates the examination of the
variable in the most unrealistic manner. For example, the change in the selling price will
divinely hamper the sales volume of the businesses.

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 Most of the analysis is based on the past data/experience which may not be of enough
value in the future and hence, the internal rate of return is affected.
 Appointing a greatest and least or hopeful and cynical worth is available to the abstract
elucidation and hazard inclination of the leader.
 It is neither hazard estimating nor a hazard lessening method. It doesn't deliver any more
clear choice principle.
Break-even Analysis
Breakeven analysis is a quantitative technique which determines the relationship between cost
and returns. It helps to find out that when the investment will reap positive returns. The survival
of a business is possible only when the revenue exceeds the cost involved therefore while
making capital budgeting decision breakeven analysis helps the manager to assess the financial
worth of the project and expected level of profits the business can earn if the prospective
investment is undertaken (Tanco, Cat and Garat, 2019).
To find out breakeven level in capital budgeting there are three different methods which are as
follows:
 TR and TC approach
 Contribution per unit approach
 Break-even chart
Importance of Breakeven analysis in capital budgeting decisions
A decision relating to make or buy: Breakeven gives an insight into the manger whether the
company should make a product by themselves or should buy from suppliers in the investment.

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Assessment of Risk: Breakeven analysis helps in gauging the risk by calculating the margin of
safety (MOS) of the project. Positive MOS suggests going ahead with the project, on the other
hand, negative MOS suggests that the business should look for other options.
The longevity of Project: Breakeven analysis helps in determining the longevity of the project
which is used in capital budgeting decisions. It also helps in finding out the most minimum
amount of business to prevent losses of the proposal while calculating the net present value
(Morano and Tajani, 2017).
Calculation of Breakeven cases
Limitations of Breakeven analysis
 Under the breakeven analysis, there is no bifurcation of the variable as well as fixed
costs. Also, there are some costs which are also inclusive of semi-variable costs, yet
there are not considered in the analysis. The price fixation and the variance analysis
between two jobs cannot be performed without considering the fixed costs.
 When the fixed costs of the two firms are similar, there is no point in the comparison
between the two companies. Further, the valuation of closing stock at marginal cost
results in the understatement of the final accounts. Subsequently, profits are suppressed
and the balance sheet is distorted (Nagle and Müller, 2017).
 The volume of the sales is unlikely to be the same as output as there may surely be some
building up stocks or piled up stocks.
Scenario Analysis
Scenario analysis is a technique of identifying and evaluating alternative possible outcomes and
analyzing deviations to determine the Net Present Value (NPV) of a potential investment.

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For Example, Scenario analysis can be used to gauge the risk of an investment by finding out
their Net Present Value if there is high or low inflation. It considers all the possibilities of the
alternatives and uses statistical methods of correlation and probability to find out the best result
of the alternatives which can yield maximum returns in capital budgeting (Arnold and Yildiz,
2015).
Importance of Scenario Analysis
Analytical tool for evaluating potential Investment: Scenario analysis is a quantitative
technique which calculates NPV of all the possible alternatives and the best alternative is chosen
which gives maximum possible returns.
Future planning: The scenarios are further divided into the normal case, best case and worst
case scenario; this helps in giving the investors an insight of the future planning and future
investments (Angilella and Mazzù, 2015).
Avoiding the risk and failure: To avoid poor investment decisions, scenario analysis allows the
businesses or investors to assess investment prospects. It also makes sure to take into
consideration the best as well as worst-case probabilities so that the investors can make an
informed decision.

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Limitations of Scenario Analysis
 However, there are certain drawbacks which can be observed while doing the scenario
analysis. Scenario analysis at times is a process which demands a lot of time and costs
too (Doss, Sumrall III and Jones, 2017).
 The expertise skills are required to perform the tasks which are not understood by all the
experts. This also creates difficulty in forecasts about what takes place in the future
whereas the actual outcome may be fully unexpected and not foreseen in the financial
modeling.
Simulation Analysis
The Simulation Analysis is a technique that is used to determine the infinite calculations that are
made to maintain the probable results and possibilities for any choice of action. Under the
scenario of the capital budgeting, the simulation analysis plays a vital role (Tacha, et al 2016).

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Importance of Simulation Analysis
Simulation is a practical punch: The process of simulation is based used in analyzing the
complex and large practical problems when the things are not possible by the way of
mathematical problems (De Souza and Lunkes, 2016).
Financial Simulation Analysis generally takes a look at the abstracted changes against the
revenues and expenses, without attaching a probable cause to them. They simply show what the
impact would be to the bottom line when different income and expense variables are adjusted.
Appointing a greatest and least or hopeful and cynical worth is available to the abstract
elucidation and hazard inclination of the leader. It is neither hazard estimating nor a hazard
lessening method. It doesn't deliver any more clear choice principle (Feng, et al 2017).
Limitation of Simulation analysis
There are several limitations while performing the simulation analysis is not going to help
deliver the optimal solutions. A good simulation model is difficult to understand and execute.
Proper training is required for understanding the concept of the simulation analysis. The model
of the simulation is quite costly and expensive and this in case results in executing the tasks, but
not on the time. The simulation model does not answer the results by itself and proper guidance
and the information shall be placed in the proper input category. The model needs proper
recognition on its own. It is found unsuitable in industries like shipbuilding, etc. If fixed
expenses are not accounted for in valuation of work in progress, the loss that is incurred every
year until the completion of the contract. It may also create income tax problems that can result
in the overall problems in the accounting performance of the business (Grisar and Meyer, 2016).

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Conclusion
From the above analysis it can be concluded that the above analysis are helpful in making the
capita budgeting decisions and are also helpful in defining which project shall be selected or not.
This sometimes acts as a planning tool, whereas at times the tool is not utilized properly and
hence, these analysis turns out to be the asset for the organizations and the enterprises.

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References
Angilella, S. and Mazzù, S., 2015. The financing of innovative SMEs: A multicriteria credit
rating model. European Journal of Operational Research, 244(2), pp.540-554.
Arnold, U., and Yildiz, Ö., 2015. Economic risk analysis of decentralized renewable energy
infrastructures–A Monte Carlo Simulation approach. Renewable Energy, 77, pp.227-239.
Borgonovo, E. and Plischke, E., 2016. Sensitivity analysis: a review of recent
advances. European Journal of Operational Research, 248(3), pp.869-887.
De Souza, P. and Lunkes, R.J., 2016. Capital budgeting practices by large Brazilian
companies. Contaduría y Administración, 61(3), pp.514-534.
Doss, D.A., Sumrall III, W.H., and Jones, D.W., 2017. Strategic finance for criminal justice
organizations. CRC Press.
Feng, K., Xiong, W., Wang, S., Wu, C. and Xue, Y., 2017. Optimizing an equity capital structure
model for public-private partnership projects involved with public funds. Journal of construction
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Hayward, M., Caldwell, A., Steen, J., Gow, D., and Liesch, P., 2017. Entrepreneurs’ capital
budgeting orientations and innovation outputs: Evidence from Australian biotechnology
firms. Long Range Planning, 50(2), pp.121-133.

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Iooss, B. and Lemaître, P., 2015. A review of global sensitivity analysis methods. In Uncertainty
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Morano, P. and Tajani, F., 2017. The break-even analysis applied to urban renewal investments:
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Nagle, T.T. and Müller, G., 2017. The strategy and tactics of pricing: A guide to growing more
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Tacha, O.I., Volos, C.K., Kyprianidis, I.M., Stouboulos, I.N., Vaidyanathan, S. and Pham, V.T.,
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