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

Running Head: CORPORATE FINANCE 1
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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.