Capital Budgeting Techniques Analysis

This assignment delves into the world of capital budgeting techniques, examining their significance in guiding investment decisions for businesses. It explores various methods used to evaluate potential projects, highlighting both qualitative and quantitative factors considered in the process. The analysis also investigates the influence of several factors on the choice of specific capital budgeting techniques.

Corporate Financial Management 1
CORPORATE FINANCIAL MANAGEMENT
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Corporate Financial Management 2
Executive Summary
Capital budgeting is considered to be a process of planning that usually used to establish if a
company's long-term investments like replacements of equipment, new machinery, new
products, new plants and research improvement ventures are worth support of cash via the
company capitalization plan. Because, resources are often limited in its accessibility, capital
investments are evaluated exclusively using both qualitative and quantitative data as most
capital budgeting examination uses cash outflows and inflows instead of net income
evaluated through the accrual basis. This assignment includes the introduction part that
provides the meaning of capital budgeting techniques. This assignment also explains
sensitivity, scenario, breakeven and simulation techniques and how all of those management
decision making can be related to capital budgeting techniques.
Capital Budgeting Techniques
Introduction
Capital budgeting practice is considered to be one of the important inputs in investment
process of making decision getting onto the investment projects. A precise good analysis,
evaluating, scrutiny, monitoring, and implementation of such investments or project could
produce the expected outcomes for the shareholders.
According to Ghahremani, Aghaie, and Abedzadeh (2012), the capital budgeting practice
aspects are used to make the decision for investment in order to increase the value of the
shareholders. Capital budgeting is mainly concerned with substantial investment in long-term
assets because these particular assets may be tangible like plants, properties, and equipment
or can also be intangible like research and development, design, new technology, trademark
and patent rights. This assignment attempts to explain how management could use sensitivity,
scenario, breakeven and simulation techniques in relation to the aspect of capital budgeting.

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Capital budgeting basically comprises of diverse techniques utilized by company executives
such as;
Payback period
This is a capital budgeting that refers to a length of time that it takes for an investor to
recover back the initial amount invested in a project or a property (Ahmed, 2013). Since
payback period is considered to be a traditional method of budgeting, managers usually
employ this particular method when determining the length of time that an investment will
pay back the capital invested.
Pay Back period = Initial Cash Outlay
Annual Cash flows
Internal Rate of Return (IRR)
This is the rate of interest at which the NPV of the cash flows that is either negative or
positive from a project or venture equals to zero. Internal Rate of Return (IRR) is utilized to
assess the project effectiveness because if the IRR of a new investment surpasses a firm
needed rate of return, then the project is appropriate (Maroyi, and Poll, 2012). The company
should reject any project that its Internal Rate of Return (IRR) falls below the rate of return
that is required company. According to Internal Rate of Return (IRR) concept, management
usually employs this particular method so as to determine the effectiveness of the project
because basically, IRR should be in excess of the return rate that is required for an invested
project.
Figure 2: Internal Rate of Return (IRR)
Net Present Value (NPV)

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The Net Present Value (NPV) is a financial accounting method that involves the discounting
of all the cash flows and computing the present cash flows value at a given discounting rate
usually called the cost of capital or the required rate of return. The initial cash outlay is then
deducted present value so as to obtain the Net Present Value. (NPV = P.V – Io). In case the
project has a salvage value, the present cost of the salvage value should be added to the cost
of the present value of the given cash flow (Daunfeldt, and Hartwig, 2014). This technique is
important for managers because it considered the time value of money and is basically
consistent with the aims of maximizing revenues for the owners.
Figure 3: Net Present Value (NPV)
Profitability index
Profitability index is considered to be the proportion of the present cost of future cash flows
of an investment to its initial project that is needed for the investment. This particular
technique is usually used by the managers in determining the ratio of the future cash flow of a
project at hand (Rossi, 2014). Basically, profitability index measures the present value of
returns that is derived from per amount invested that will show the basic relationship between
the cost and the benefits of the project.
Figure 4: Profitability index

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How all of those management decision making can be related to capital budgeting
techniques
Sensitivity Analysis
Sensitivity Analysis is basically reffered to as the technique that is utilized to determine how
different values of an independent variable might impact a specific dependent variable in a
provided set of estimates (Ahmed, 2013). It is usually used in specific limits that will rely on
more or one input variables like the impact that varies in rates of interest will contain on a
price of a bond. Sensitivity Analysis helps in measuring the sensitivity of a decision to the
changes in the variables of one or more parameters. This particular analysis is considered to
be a way of examining changes in the projects Net Present Value for a provided variation in
one of the variables. Sensitivity Analysis basically shows how profound the projects IRR or
NPV are to the changes in a particular variable. The more sensitive is the Net Present Value,
the more acute is the variable (Brunzell, Liljeblom, and Vaihekoski, 2013).
Steps encompassed in Sensitivity Analysis usage
 Identify all the variables that have an impact on the investments NPV or IRR
 Define the fundamental correlation in the variables.
 Analyze the impact of the changes in each of the resultant variables on the
investments Internal Rate of Return or Net Present Value.
The maker of the decision while executing the aspect of Sensitivity Analysis considers the
investments Internal Rate of Return or Net Present Value for each projection in three
assumptions; optimistic, expected or pessimistic (Cooper, Cornick, and Redmon, 2011).
Basically, sensitivity analysis allows asking what if questions. For instance, what is the
Internal Rate of Return or Net Present Value if the volume decreases or increases? What is
the IRR or NPV if the price decreases or increases?

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The technique has been proved to be static since it only analyzes one factor at a particular
time that basically makes the managers rely on their personal judgment. Even though the
technique is considered to be good, it may need managers to have more skills on how to carry
out break-even analysis and correlation that may make it complex to be used in small and
medium companies especially in the developing countries, and this hence makes the
technique less applicable in less developed or developing nations (Rossi, 2014).
Sensitivity Analysis helps an organization approximate what will occur to the projects if the
estimates and assumptions turns out to be unpredictable since it often encompasses changing
the estimates or the assumptions in a calculation in case the investments does not produce
projected outcomes, so they can better analyze the venture before contemplating for
investment. This aspect is useful to managers because they will have a clear perspective of a
project before moving on to invest in the project.
Scenario Analysis
While sensitivity analysis is considered to be the most commonly utilized tool for accessing
the risk of the project, the managers are usually interested in knowing how the project will
behave if diverse variables change at the same time. Basically, scenario analysis is considered
to be a tool that overcomes the limitation of the sensitivity analysis. It often measures the
change in Net Present Value of the project under different scenarios, changing diverse
variables at a time because of the interrelationship of variables among themselves. Scenario
Analysis is the technique of analyzing probable future activities by considering possible
different results (Burns, and Walker, 2015).
Numerous scenarios are established in a scenario analysis to demonstrate probable future
results, and it is basically used to produce a combination of an optimistic, pessimistic, and
most probable scenarios. Scenario analysis commonly emphasizes on estimating the value of
the portfolio that could decrease to, if an unfavorable activity of the worst case was realized.

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The first step in utilizing this particular technique is to determine the Internal Rate of Return
or Net Present Value then identify all the possible errors of these particular cash flows and
the investigate the major effect or impact of diverse assumptions on the Internal Rate of
Return or Net Present Value. In reality, scenario analysis cannot be used to determine the
project alone; it can also be utilized to supplement other evaluation techniques by identifying
the factors that affect the cash flows of the project such that company managers or directors
can consider them (Baker, and English, 2011).
Scenario Analysis offers a means to evaluate the potential variability in a capital budgeting
projects Net Present Value for managers. By carrying out a scenario analysis, an investor can
basically produce a risk profile for a forecasted investment and build a basis for comparing
prospective projects or investments that can enhance production.
Break-Even Analysis
Break Even Analysis focuses on the determination of minimum volume per revenue that
would result in recovery of all expenses. As long as revenue results, the profit variation is
considered an issue by the management because the main aim of the management is not to
make any loss. Under Break Even Analysis, managers can make an assessment that regards
probability of not attaining the Break Even level of sales. The lower the Break Even or
further the expected level of operation from the Break Even point, the safer the projected
anticipated. This particular aspect is referred to as the margin of safety (Hasan, 2013).
Though a simplistic perspective of risk, it basically serves the objective of risk assessment.
Break Even Analysis requires a minimum amount of data as nor other input are needed
besides those already prepared for evaluation of information.
Each method has its own demerits and merits and the ability of the shareholders in the
project. If a particular method is inferior or superior depends on the situation. For instance, it
would be purely fruitless and impractical to run a simulation activity for a paltry investment.

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Similarly, financial institutions while offering financial assistance to a project, they depend
heavily on sensitivity analysis because simulation or scenario analyses are too big for them.
However several managers who have to take a number of critical decisions are considered to
be more concerned with Scenario Analysis that the Sensitivity Analysis during capital
budgeting. Break Even Analysis works like sensitivity analysis in capital budgeting because
it basically analyses price, cost and sales volume and how they impact of the organization
revenues or profits. The techniques are useful to managers during capital budgeting because it
shows if the project Break Even in the accounting terms (Chai, 2011).
Break Even Analysis is also vital for managers when performing capital budgeting because it
often facilitates the managers to have a clear perspective of the project or investment he or
she plans to undertake in that projects or investments that break even early is considered to be
viable investments that should be invested on.
Simulation Analysis
Simulation Analysis technique is considered to be a technique that combines both the
scenario and sensitivity analysis in analyzing risks in a particular risks project cash flows. It
basically identifies the main factors that affect their interrelationship and the profits. These
cash flows are embedded to demonstrate the main factors that influence the payment and the
cash receipt and their interrelationships (Bierman and Smidt, 2012(. Even though according
to the capital budgeting perspective, Simulation Analysis technique theoretically looks good
but in practice, it may be complex and expensive to be utilized especially for small and
medium business and also in the developing nations since it requires the use of computer
software.
Simulation Analysis technique is also referred to as a computer-based exercise that generates
a large number of situations and computes Net Present Value of each of them so as to find out
the distribution of Net Present Value, its projected standard deviation and the value as a

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measure of risks. Simulation Analysis or Monte Carlo Simulation technique considers the
interaction among variables and the probabilities of the change in the variables. It basically
computes the probability distribution of the Net Present Value. Basically, the Simulation
Analysis encompasses the following steps;
 Identification of exogenous variables that impact cash outflows and inflows of the
project and its Net Present Value such as selling price, demand, size of the market and
variable costs (Hise, and Strawser, 2013).
 Understanding the relationship between the Net Present Value and the variables such
as profits depends on sales prices and volume, the volume of sales basically depends
on the size of the market and market share.
 Specification of the probability distribution for each of the exogenous variable.
 Finally, developing a computer program that randomly selects one value from the
probability distribution of each variable and utilizes this value so as to calculate the
project’s NPV.
Simulation Analysis basically overcomes the limitations of scenario and sensitivity analysis
by basically analyzing all the effects of all the possible combinations of the variables and
their realization (Rossi, 2015). Even though there is no difference with the inputs like in
scenario analysis, this technique treats the estimates as a triangular distribution with the
possibility of worst case and best case working capital being close to zero and also increases
linearly up to the most likely case.
Conclusion
Because, resources are often limited in its accessibility, capital investments are evaluated
exclusively using both qualitative and quantitative data as most capital budgeting
examination uses cash outflows and inflows instead of net income evaluated through the

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accrual basis. Capital budgeting techniques are vital tools that enhances the company
management to determine the most viable investments to undertake that have high returns.

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Bibliography
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techniques. Journal of Finance and Investment Analysis, 2(2), pp.77-88.
Baker, H.K. and English, P., 2011. Capital budgeting valuation: Financial analysis for
today's investment projects (Vol. 13). John Wiley & Sons.
Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of
investment projects. Routledge.
Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.
Brunzell, T., Liljeblom, E. and Vaihekoski, M., 2013. Determinants of capital budgeting
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Cooper, W.D., Cornick, M.F. and Redmon, A., 2011. Capital budgeting: A 1990 study of
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