Capital Budgeting Techniques for Decision Making

Break-even analysis is a technique used in capital budgeting to determine the effect of efficiency and cost on overall profitability, while also analyzing variable and fixed costs. It helps predict the impact of changes in prices and calculates profits and losses at different sales levels. However, it has limitations such as assumptions that sales prices do not change with output and production/sales may not be equal. Simulation analysis is another method used to forecast outcomes by modeling projects, calculating NPV values, and repeating steps to obtain simulated results. It allows for predicting uncertain events and considering interrelations. While both techniques have advantages and disadvantages, they are important tools in capital budgeting and can help management make informed decisions.

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Table of content
Cover page…………………………………………………………………………………………...1
Table of content………………………………………………………………………………………2
Sensitivity Analysis……………………………………………………………………………………3
Scenario Analysis…………………………………………………………………………………...3,4,5
Break even Analysis…………………………………………………………………………………5,6
Simulation Analysis………………………………………………………………………………….6,7
Conclusion……………………………………………………………………………………………7
Analytical Example………………………………………………………………………………..…7
References……………………………………………………………………………………………8,9
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SENSITIVITY ANALYSIS
Sensitivity analysis is the accounting tool used by top management in companies to make a deep
analysis for a given scenario. This analysis is also referred to as what-if-analysis as it commonly
involves the process of getting an insight into the possible outcome of a given event. It is used to
determine the important and unimportant factors on the greater profitability of the business. Top
management involves this analysis in the process of capital budgeting so as to have an insight of the
likelihood of the rapport that may ensue between various parts of the project sales, contribution,
liquidity and the working capital management of an entity (Жамойда, О.А. and Мацюк, М.С., 2011)
The purpose of the analysis is not to solely determine risk but rather to determine the reaction of
NPV to various factors used in its calculation. This is due to the fact that the process of NPV involves
some assumptions founded on forecast thus rendering it uncertain. Sensitivity analysis is one variable
of the commonly used analysis tool to measure the extent of change in factors and the related
assumptions that would have the impact on the profitability and the projected cashflow. The process
of allowing managers to appraise a project before allocating resources to it is paramount as it gives the
manager an insight of what the project would contribute toward the overall success of the
business(Cooke-Davies, T.J., 2001)
Sensitivity analysis tool as analysis tool has a various advantage such as 1.simplicity- in that there is
no complicated theory involved as opposed to the most concept in accounting and finance where the
certain theoretical concept has to be appreciated before a method is applied.2.It helps in directing the
management`s effort. It identifies important areas as far as attainment of the organizational goal is
concerned and any facet which is regarded as highly sensational will be highly monitored.3.Source of
information through the use of this analysis, various information is availed to the management in the
form that aid in the use of professional judgment.
Notwithstanding its advantages, sensitivity analysis has got some disadvantage in that it fails to
provide clear result as the term pessimistic and optimistic may have a different meaning to different
people. Furthermore, it focuses on the relationship between factors for instance sales volume may be
related to cost but each factor is analyzed in a different manner.
SCENARIO ANALYSIS
Scenario Analysis is a way in which possible future events are ascertained and analyzed. It is a very
crucial tool in finance and in economics and it is used extensively to make future projections. It does
not try to manifest one specific scenario but rather the alternative possible outcome. The main aim in
carrying out the Scenario Analysis is to estimate the risk associated with a specific plan against
different situations that could possibly arise as the plan unfolds. Scenario analysis is not dependent on
the past outcomes.
Scenario Analysis is a way of configuring some thought about the future. Outcomes are evident based
on different expected scenarios and so are the avenues that lead to that scenario from the current state
of affairs, hence giving the institution more space to vary plans accordingly. Extremely positive or
negative scenarios allow are stress-tested and proper risk mitigation done if considered appropriate.
An example of a scenario is that involving” good, middling and bad “This kind of levels allows for a
prudent spread of insights. It is also likely to come up with other types or levels of scenarios, But
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caution should be exercised to avoid excessive scenarios as the law of diminishing returns may
rapidly come into action and the extra complication may hinder the realization of useful results.
They are three basic and general approaches used in Scenario Analysis;
‘’Base case scenario’’-it is a scenario that is considered average based on the assumption from the
management. For instance, when calculating the NPV, the rates mostly used are cash flow growth
rate, discount rate and tax rate.
‘’Worse case scenario ‘it considers the worst or severe result that may occur in a given scenario. For
an instant, when calculating the NPV, the highest likely discount rate is taken and the possible cash
flow growth rate is subtracted.
‘’Best Case Scenario ‘This is the optimal projected scenario and it is most likely implemented by the
management to achieve their goals. For example, when calculating the NPV, the least possible
discount rate, lowest likely tax rate or highest possible growth rate is used.
They are myriads of benefits of performing scenario analysis in finance. These include: Future
planning-this gives the investors an idea of the risk and returns involved in a future investment. It also
helps investors to be proactive-thus investor can avoid and decrease possible loss that results from
factors that are uncontrollable. Scenario analyses help in avoiding risk and failures by assessing
investment possibility. Lastly scenario analysis aid in projecting investment losses and returns. By
virtue of the tools used it is possible to calculate the values of the potential gains or losses.
Notwithstanding the said benefits, scenario analysis has got a number of limitations that make it
difficult to be solely depended on by top management when making company`s financial decision or
when there are budgeting for their available capital. First and foremost scenario analysis is very
limited to a few discrete outcomes and may fail to clearly capture another possible outcome that may
be envisaged if a more rigorous analysis is carried out. Therefore, this analysis limits the decision
makers to explore other possible outcomes that may be attributed to a certain project hence leading to
making wrong conclusions. Secondly coming up with the scenario probabilities has proven to be
difficult as it is mostly based on individual discretion due to lack of a standard procedure for getting
those probabilities. Thirdly, Scenario analysis make an assumption of a excellent interrelation
between the inputs in the best case and worst case scenario. This assumption is a rather exaggerated
assumption and may lead to making the wrong conclusion regarding a certain decision. Lastly, the
scenario analysis technique does not provide a decision rule from which one can accept or reject a
decision. This limitation gives room for final decision to be arbitrarily determined hence rendering the
whole process unreliable and undependable.
BREAK-EVEN ANALYSIS
This analysis aims at finding the level of sales that will ensure the business will not operate under the
loss or in other words`` how much can the sales be downsized and the business proceed to make
profit’’. It is that level of sale that the company will make zero profit. This method finds the sales
required to break-even. (Alhabeeb, M.J., 2012 )
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The breakeven point is that point where sum total of income is equivalent to the sum total of
expenses i.e fixed and variable cost. It is that point that is similar to the level of production, below
which the company operate at a loss. Break even analysis involves grouping two main production cost
i.i variable cost-those cost that varies with the different meaning of output fixed cost-those costs that
are indirectly related to the output production (Tsorakidis, N., Papadopoulos, S., Zerres, M. and
Zerres, C., 2011). Total fixed and variable costs are then compared with revenue from sales to get the
amount of sales at which the company makes no profit and no loss. This analysis is a very important
tool because it is used by managers to project the results of their plans. In this regard, It computes the
value of sales which the business or company breaks even. Thus this tool is indeed pivotal in the
budget making process or in cases there is development of a new product. The breakeven point
formula is used where the business determine the exact amount sales item that is required to give a
certain level of profit. Also, the marketing department of the company can make use of break even
analysis to determine the results of an increase in the amount of production or when considering the
alternative of venturing in machinery that involves high technology..
Break even analysis operates under three keys assumption. First is the Mean price per unit sales-this
constitutes the price received per unit of sale made. The sales figure is obtained from the sales
forecast. Secondly, this analysis assumes Average cost per unit of output- is the variable cost of each
unit of sales. For example, if one purchase good for resale, then this cost constitutes the amount one
pay for, on average, for the goods that you resale and in case of offering services, it constitutes what
cost an individual per unit of service delivered. Thirdly is the monthly fixed costs-fixed cost are those
type of cost that would continue even if one goes bankrupt. In this case, it is recommended that
regular running fixed costs be used because it gives one a better insight on financial realities.
Break even analysis enables the company to ascertain the effect of efficiency and cost to the overall
profitability of the company. It also aids in analyzing the relationship that exists between variable and
fixed cost. Using the break even analysis it is possible to foretell the effect that will ensue due to
change in the prices of goods and services that that particular company offers and lastly it makes it
possible to calculate profit and losses that are realized at different levels of sales and production.
However Break even analysis has a number of limitation which includes: The assumption that sales
prices do not change at all levels of output, this is not practically true as the sales prices are subject to
variation depending on the status of the economy. It also makes an arise assumption that production
and sales are the same. This may not be true as what is produced is not necessarily what is sold. The
break even charts take quite a lot of time to prepare and hence it is time-consuming and lastly the
break even analysis can be applied to a single product.
SIMULATION ANALYSIS
This is a method where countless calculations are used to get the likely outcome and the possibility
for any choice of action (Smith, D.J., 1994). The simulation analysis can be understood by virtue of
the following steps.1.modelling the project-this shows how the NPV is related to the exogenous
variables. The parameters constitute those variables that are specified by the decision maker and are
held constant. The exogenous variables are determined randomly and are out of control of the
decision maker.2.The second step is to get the values of the parameters and attach the probability to
the random variables that arises from the outside factors.3.select any value from the probability
distribution of the independent variables.4.Calculate the NPV of randomly generated independent
variables and the parameters values.5.Repeat the two above steps to obtain a large number of
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simulated values of NPV.This simulation analysis forces the decision makers to consider all the
interrelation and uncertainties surrounding the project.
Simulation analysis has an advantage over other techniques as it allows to foretell things that never
happened before and to run situations out of the historical confines. However, theories that are
satisfactorily predictive are rare to come by and it may take years to develop. Despite simulation
being applicable to a variety of context, a formal set of best practice and rules is not available and for
this reason, the simulation modeling may be difficult for new researchers who may lack references to
refer from.
CONCLUSION
Thus the above various techniques for capital budgeting may be employed in undertaking capital
budgeting process by the top management. As it has been indicated each technique has its advantage
and disadvantage and as such the best technology should be used depending on what plan. It is only
prudent for the management to subject any project that they want to undertake to several of the
discussed techniques because the use of one independent technique may not reveal all the result that is
required to make the final decision. Therefore all of the discussed techniques are important as far as
capital budgeting is concerned and are hence extensively used by top management of various
companies to define the viability of a project.
ANALYTICAL EXAMPLE: BREAK EVEN ANALYSIS
A company expects to sell 20,000 units at $20 each. The variable cost per unit is $10 and the fixed
cost is $20,000 per annum. Calculate breakeven point in units and in sale revenue.
Breakeven point= fixed cost divide by (sales price per unit minus variable cost per output)
=20000/20-10
=20000/10
= 2000 units
To get the sales revenue at break even point, the web divide the fixed cost by the contribution to sale
ratio i.e $20,000/0.5=$40,000
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REFERENCES
Жамойда, О.А. and Мацюк, М.С., 2011. Sensitivity Analysis in Capital Budgeting.
Cooke-Davies, T.J., 2001. Towards improved project management practice: Uncovering the evidence
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Alhabeeb, M.J., 2012. Break‐Even Analysis. Mathematical Finance, pp.247-273.
Smith, D.J., 1994. Incorporating risk into capital budgeting decisions using simulation. Management
decision, 32(9), pp.20-26.
Ross, S.A., Westerfield, R., Jaffe, J.F. and Roberts, G.S., 2002. Corporate finance (Vol. 7). New
York: McGraw-Hill/Irwin.
Shapiro, A.C., 2005. Capital budgeting and investment analysis. Prentice Hall.
Ho, S.S. and Pike, R.H., 1991. Risk Analysis in Capital Budgeting Contexts Simple or Sophisticated?.
Accounting and Business Research, 21(83), pp.227-238.
.Truong, G., Partington, G. and Peat, M., 2008. Cost-of-capital estimation and capital-budgeting
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.Goyal, B., 2012. Break-Even Analysis.
Tsorakidis, N., Papadopoulos, S., Zerres, M. and Zerres, C., 2011. Break-Even Analysis. Bookboon.
Ross, S.A., Westerfield, R., Jaffe, J.F. and Roberts, G.S., 2002. Corporate finance (Vol. 7).
New York: McGraw-Hill/Irwin.
Magni, C.A., 2009. CAPM and capital budgeting: present versus future, equilibrium versus
disequilibrium, decision versus valuation.
Ghahremani, M., Aghaie, A. and Abedzadeh, M., 2012. Capital budgeting technique selection
through four decades: with a great focus on real option. International Journal of Business and
Management, 7(17), p.98.
Hornstein, A.S. and Zhao, M., 2011. Corporate capital budgeting decisions and information
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