Capital Budgeting Techniques Analysis

This assignment delves into the analysis of capital budgeting techniques. It outlines the process of identifying variables related to cash inflows and outflows, determining probability distributions for each variable, and utilizing a computer program to simulate various project profitability scenarios. The analysis highlights the importance of understanding these techniques in investment decisions while acknowledging their limitations in capturing all potential uncertainties and interrelationships between variables.

CORPORATE FINANCIAL MANAGEMENT

The main basis on which an organization is established is based on the decisions made by its
management. Hence, the process of decision-making has become an important part of the
business because even one inaccurate command may prove to become hazardous for the firm
resulting in huge losses in profit and status of the firm. Before coming to the conclusion of any
case we should examine all the major factors which may affect the goal of the management.
Therefore they should choose the most appropriate option in order to achieve their desired
results. The decision-making process is having a main objective of accomplishing the 'goals' and
it is also a continuous process because of the dynamic nature of the business environment which
leads to change in plans because of new problems arising with a change in time (Berman, Knight
and Case, n.d.).
There are different levels of the firm at which the corporate decision-making takes place like-
bottom up or top down. The executer characterizes the corporate decision-making as the decision
will be most appropriate only when it is taken effectively. Also, if there is no commitment from
the lower or middle management, the large laid plans may become useless which may lead to
failure of the management system. It is therefore important for the management to maintain a
prospering and healthy relationship with intermediate and low-level management. Therefore,
business decision-making is successful, as long as there will be ”glue” which will help the firm
to be organized and also will lead to encouragement of the leaders who maintain stability in the
business values, otherwise the entity will fall into their own trap, leading to the loss of
competitiveness of the market (Bruner, Eades and Schill, 2017)..
Capital budgeting refers to the assessment of the various costs or investments with properties of
huge nature .These costs or investments include the creation of new plants or long-term
investments (Clarke and Clarke, 1990). It helps in determining lifelong cash inflows and
outflows to assess whether favorable returns are incurred by the firm to accomplish the set goals
or benchmark and thus it is also called “investment appraisal”.
For an enterprise, it helps to facilitate the use of all opportunities and projects, but because of the
limited availability of capital at a particular point in time, management uses the technique of
capital budgeting to determine the maximum return on all available assignments at a time
(Fairhurst, 2015).
There are various methods of capital budgeting which includes net present value (NPV), internal
rate of return (IRR), discounted cash flow (DCF) and payback period. This can be explained as
follows:
 NPV: There is a discrepancy between the present values of both the cash inflows and
outflows which is used in capital budgeting to find the profitability of the project or long-
term investment. A positive value of NVP indicates that the expected return exceeds the
cost whereas a negative value indicates a loss in the business (Galbraith, Downey and
Kates, 2002). For example- If there are two assignments A and B, and both have different

structures of cash flow, also the required rate of return is 10.25% then the NPV of the
cash flows will be shown as follows:
Project
A
Year
Cash
Flow
0 -90000
1 25000
2 24000
3 26000
4 27000
5 30000
Required rate of Return 12%
NPV of
Project A
Yea
r
Cash
Flow Present Value of Cash Flows
0 -90000
-
90,000
1 25000 22,321
2 24000 19,133
3 26000 18,506
4 27000 17,159
5 30000 17,023
NPV 4,142

 IRR: It may be defined as the net interest rate at which all the cash flows will have an
NVP equal to zero in a provided assignment or investment. The attractiveness of the
investment may be calculated using this method. The rule says that if the internal rate of
return of a new project exceeds the rate of return that the company requires, then the
project is acceptable (Hassani, 2016). Also if it will be less than the company’s required
rate of interest then the project is not acceptable. We are calculating the IRR from the
same example we have taken for NPV:
For Project A:
For Calculation of IRR,
Inflow=Outflow
Let be IRR 13.78% then
PV of Inflows
Year Cash Flow Present Value of Cash Flows
1 25000 21,972
2 24000 18,539
3 26000 17,651
4 27000 16,110
5 30000 15,732
90,005
Therefore, at 13.78% Pv of Inflows = PV of Outflows (90,000). Hence IRR is 13.78%
 DCF analysis: These are similar to the NPV analysis because it takes into account the
initial cash outflows which are needed for funding a project, cash inflows and other
future outflows in the form of maintenance and other expenses. Such costs are being
discounted to the current date and the outcome number is known as NPV (Holland and
Torregrosa, 2008).
 Discounted payback period: This is a capital budgeting process that determines the time
required to break down the cost of initial expenditure by analyzing and discounting future
cash flows and monetary time values (Khan and Jain, 2014). By the rule, if the projects
which are discounted with the payback period are less than the targeted period, then the
project should be accepted and processed.
Importance of capital budgeting techniques is as follows:
 Evaluation of risks: Long-term investments are the capital expenses that contain
noticeable and significant financial risks. Therefore, it is really important for a firm to

access the capital budget for proper planning and functioning (Palepu, Healy and Peek,
2016).
 Finding the best course of action: It helps a firm to access all the possible course of action
available in a particular project and then choose the best investment to attain the
maximum possible returns on it. The main focus is of increasing shareholder wealth and
helping the company to gain an advantage in the marketplace.
 Long run of the business: The capital budgeting helps to reduce costs and also helps to
determine the company's best and maximum profit (Phillips, 2014). Capital budgeting
helps to make the business sustainable for long-term by helping it in accessing proper
planning, analysis and avoid all inadequate investments.
 Irreversible Investments: Sometimes the firm need huge investments but the funds are
limited. So, it is better to analyze all the provided information of the project before
making any investment. Once a decision is made, the money which is being invested will
have no option of reversing the payment.
There are various types of capital budgeting techniques such as:
 Sensitivity Analysis: In this, there are several different forms of variables which help to
determine the outcome of a decision by doing a complete analysis. Assuming the certain
conditions to be constant, the analyst determines the change in the dependent variables
based on the different values of the independent variables. It is also called “What if
analysis” (Reilly and Brown, 2012). This type of analysis may be used by anyone for any
type of decision like the planning of a family vacation or making corporate-level
decisions. The main concept of sensitivity analysis is to determine the changes in output
based on the change in one input, keeping all other inputs constant.
For conducting sensitivity analysis, following steps should be kept in mind:
 The base case output may be defined by taking an example; like NPV at a particular base
case input value (V1) for which the sensitivity needs to be measured after having all other
inputs constant.
 Keeping all other inputs same, the value of output may be calculated at a new value of
input (say V2)
 Then the calculation of %change in input and % change in output is carried out.
 At last, the sensitivity is determined by dividing the % change in output by % change in
input.

After all the calculations, it may be concluded with the fact that higher the sensitivity figure will
be, the more sensitive the output is to any change in respect to input and vice-versa.
 Scenario analysis: It is the process of calculation of the “expected value” of an asset in a
specific time period assuming many differences in the value of factors such as interest
rates, etc (Saltelli, Chan and Scott, 2008). It is also a technique where analysis is done by
a certified analyst in order to calculate different reinvestment rates for the expected profit
which are continuously invested in the business during a specific time period. This
analysis helps to find changes in the estimate of the portfolios which are based on the
happenings of the environment and thus follow the principle of “What if analysis”. The
assessment may be used in determining the amount of risk present in the amount which is
going to be invested which is relied on the various potential events, having high and low
range probabilities. This analysis may help the investor to determine the level of risk that
can be undertaken before investing the money anywhere.
There are several methods of approaching scenario analysis of which the most common is called
standard deviation of daily or monthly security returns which is generally calculated to compute
the expected value of the portfolio. This is the most appropriate method for an analyst, which
may help him to analyze and determine the reasonable changes in the values of portfolios at a
particular period of time (Saunders and Cornett, 2017).
It should be noted prominently that the two above-mentioned analysis are not the same. This may
be better to understand using an example like if an equity analyst has a wish to conduct both
sensitivity and scenario analysis to know the effect on the Earning per Share (EPS), he will
calculate it by using the price to earnings (P/E) multiple.
The sensitivity analysis is dependent on the variables that affect the calculation and which can be
described using the price of the variables and the EPS. The range of all possible outcomes is
being recorded with the help of this analysis whereas in scenario analysis, the outcomes are
determined on the basis of the situation or present environment of the firm. It should be checked
by the analyst he need is updated about the scenes like market crash or any change in the rules
and regulation of a company. Then he uses the various variables of the model in order to
accommodate the present situation. If all of these factors are integrated together, the analyst
understands the different results with a broad view, including all the results in all extreme cases,
and uses different combinations of inputs of real life cases to determine the outcome.
 Break Even analysis: The Company’s break-even point can be defined as the point where
the company is generating enough income so as to cover all costs and expenses which are
incurred during a specific accounting period. According to the definition, there will be no
profit or loss incurred as a result of which the company’s net income will be zero. It is
necessary to note that the company is not using the payback period to determine the
breakeven point as the payback period is related to pay back an initial investment in a
particular period of time whereas the breakeven point is related to zero net income after

calculating the total revenue and total costs to be equal. This analysis helps us to
determine that how much sales is needed in order to return all the cost incurred in doing a
business. The following points are needed to be considered:
Accounting breakeven analysis: When the total revenue equals the total cost and the net
income is zero, then accounting breakeven analysis takes place. This can be achieved
when we calculate the ratio of variable cost to sales. Taking an example, if there is a
given ratio of 0.65 then this states that with every rupee of sales of each unit, the
contribution is 0.35. Thus, the contribution margin ratio comes to 0.35. Therefore the
breakeven point can be calculated by the following equation:
Breakeven Point = (Fixed Cost + Depreciation) /Contribution Margin Ratio.
If the depreciation is not added, then the same breakeven point is known as cash breakeven point.
The value which touché the breakeven points show that there are zero returns on the sales. Thus,
because of no profit, only the amount of money invested will be recovered.
Financial breakeven analysis: NPV breakeven occurs when the initial investment is
equal to the cash flow, that is, the net present value is zero. Therefore, in order to
achieve the breakeven point, the analyst needs to access that amount of sales where
the net present value is equal to zero.
 Simulation analysis: The term simulation means imitation of a situation or process.
Monte Carlo simulation is an analysis of the pretending of the different processes of some
real things or star of affairs which represent the key features of a system using random
numbers. It usually means to add up the dimensions of the dynamic analysis to the capital
budgeting as it contains the process of making up for several different situations which
are respective to the assumptions made by the analyst about the risk factors present. It
also looks after its interaction and several possibilities of changes in the variables. The
following steps are to be followed to perform this analysis:
 Identification of the variables needs to be carried out for both cash outflows and inflows.
 All the formulas relating to the variables should be mentioned and then the determination
of probability distribution for each variable should be carried out.
 Then, a computer program will be made in order to randomly select one value from the
profitability distribution of every variable present and then determine the projects net
present value using such values.
 The result of this calculation is not a small value but it is rather a profitability distribution
of all the feasible expected returns.

It is a useful tool to improve the decision-making for investments by understanding the capital
budgeting techniques till its depth. Howsoever, some uncertainties are not in the condition to be
controlled. Hence, this type of analysis is not the perfect answer for all the problems as it may
overlook the significant interrelationships present between the variables and thus may lead to
wrong results with inappropriate conclusions (Shim and Siegel, 2008).
Capital budgeting techniques are important for the decision-making process, but there are certain
limitations:
 Unknown and inappropriate investments make it hard for the firm to prepare a proper
budget.
 All the decisions are needed to be analyzed carefully as they contain decisions pertaining
to large amounts which are irreversible in nature.

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