Methods of Financial Analysis in Capital Budgeting

This report discusses various methods of financial analysis in capital budgeting, including sensitivity analysis, scenario analysis, break even analysis, and simulation analysis. It highlights the benefits and drawbacks of each method and their application in decision making. The report also emphasizes the importance of accurate data and reliable forecasts in these analyses.

Operate financial
management

Table of Contents
INTRODUCTION...........................................................................................................................5
TASK...............................................................................................................................................5
1. Sensitivity analysis:.................................................................................................................5
2. Scenario analysis:....................................................................................................................6
3.Break even analysis:.................................................................................................................7
4. Simulation analysis:................................................................................................................9
CONCLUSION .............................................................................................................................10
REFERENCES..............................................................................................................................12

INTRODUCTION
For getting competitive advantages, company needs to opt various tools that could be
used in the business for analysis which would also assist in making strategies for the firm. These
tools are to be conducted by considering various ways. Whole project are required to be made by
opting several techniques and information is gathered by way of collecting various data. Under
this report, various methods are to be considered with the help of several key techniques. Under
this report, various analysis reports are discussed (Smit and Watkins, 2012). These would be
sensitivity analysis, scenario analysis, Break even analysis and other simulation process.
TASK
1. Sensitivity analysis:
Various investment decisions are made with the help of capital budgeting process. Under
this analysis, consideration are required to be emphasised for several factors which are the risks.
By analysing forecasted and the actual outcomes, variance occurred which would enhanced risks
factor. There are so many hypothesis made, and the ways or the level under which NPV is
affected by varying in them and that would be identified with the assistance of sensitivity
analysis. With the help of sensitivity analysis, the variation on is identified. By implementing
several components on net present value or internal rate of return would be identified. By
implementing such changes under variable factor on NPV or IRR is determined (Lusardi, 2012).
The risks is assessed and management is striving hard to eliminated it in most effective manner,
and also make decisions accordingly, so that the optimum return can be taken. The key object of
capital budgeting is attained by opting sensitivity analysis.
For making the best sensitivity analysis, the company is required to adhere entire steps that are
emphasised under this regards will be followed that would be covering the followed steps:
 In respect of variables, forecasting would be made that is implemented to reach at
specific conclusion.
 The level upto which forecasting would be determined by investigation whole chooses
variable.
 Future examination are to be framed in order to determine any wrongful changes.
 Whole variation could be found and recorded under percentage form.

With the help of above mentioned procedure, various benefits would be received by the company
in order to avoid the company from various losses. However, there are so many benefits or
drawbacks that are linked to it and are rendered under it.
Illustration 1: NPV sensitivity analysis
(Sources: Sensitivity analysis, 2017)
Benefits:
 Sensitivity analysis is the main assumption that are made in order to identify of risks that
would be implemented to make deal with them (Schaeck and Cihak, 2012).
 Such process covered in estimated would become more healthy by implementing
sensitivity.
Drawbacks:
 The outcomes would be better if the gathered data is adequate and reliable.
 At once, only one hypothesis is made.
 It is the not an easy task for the managers to determined it as the procedure covered
under this complex.
So entire above mentioned factors are required to be considered at the time of performing the
analysis that would be identifiable for making strategies.

2. Scenario analysis:
Under each organisation, there are so many activities that are required to be considered,
and the investment amount is needed to be determined (Grinblatt and Titman, 2016). For this,
various situations are there and integration of all the situations are framed by taking probabilities
under this. With the help of this, various value would be determined.
Scenario analysis uncover the risks which includes the investment. Various decisions are made
via comparing of risks that would be estimated with the help of expected return to be attained.
Under this, the patience level of investors are to be considered under situation analysis, which
would be beneficial to frame appropriate decisions. With the help of investigation of several
situations, entire possible results are determined.
To make the procedures smooth and effective, the company is required to consider
various benefits or drawbacks so that an adequate plan is made in order to overcome them.
Advantages:
 With the help of scenario analysis, various outcomes are provided and the company
selected best option among all.
 Managers are required to implement various explanation that are used for identification
of NPV and deviation that could be considered.
Disadvantages:
 There are few discrete results which would be limited.
 Under scenario analysis, it is assumed that there would be the sound correlation between
the inputs of the best and worst case (Meng, Zhao and Shen, 2011).
 By implementing this, a perfect decisions cannot be made in respect of the proposal to be
considered or rejected.
There are various points which are required to be written by the firm in order to get the business
advantage. With the help of this, capital budgeting assist in order to determined the project
combination which could be chosen and to be the effective help.

Illustration 2: Scenario analysis
(Source: Scenario Analysis, 2017)
3.Break even analysis:
Decision taking is an important part of an organization. In order to get higher profits it is
necessary that the right judgement is made after analysing the present situation and also doing its
analysing in a proper manner so that all the associated risk is determined. IRR i.e. internal rate
of return is the rate which an organization receives against the investment made by it. To
maximize the profit this is very important that source which has the capacity to give maximum
returns is chosen from all the available options (Sharan, 2012). Due to change in the external
surrounding that keeps on taking place frequently it is necessary that such option is chosen which
can give long term benefits to the organization. For this management needs to decide that which
option will be least effected by the change that take place.
This is the analytical tool which helps the firm to identify the no profit no loss situations.
According to this, company found the point where company's entire expenditure is equal to the
sales. As this analysis helps the firm to make their business strategies effectively so that

company could attain competitive advantages over the other rivals (Andrews, 2011). Under this,
company reach to the points, where no profits, no loss arise. By using break even points, the
margin of safety is calculated so that the sales of the company would raise and company is able
to earn profits (Schaeck and Cihak, 2012). Under this method, the company analysed the cost
which indulge in sales. Under this method, the vary in demand does not change as the change in
the quantity demanded. This provides a most effective manner under capital budgeting as by
BEP, decisions would be made in order to get the desired profits. The costs are divided into
variable and fixed overheads under production of goods. Fixed cost is the fixed and does not
change as the change in production. But, if the production becomes more then the fixed cost
would become lesser and that would help out in making the product cheaper. While the other one
is variable cost. This cost changes as per the change in production (Madura, 2011). This is used
for identifying per unit contribution. Contribution can be attained by reducing the variable cost
from the selling price.
At that point fixed overheads is divided by the amount and BEP in quantity is identified.
And then the decision is required to be made accordingly. It is selected if the volume will be over
the break-even point then that will be acknowledged else it should be ignored. The organization
should influence such arrangements by which every one of the deficiencies to will be overcome
will be distinguished. They will be utilized with the goal that all the coveted results which are
predefined can be accomplished.
Illustration 3: Break even point
(Source: Break even point analysis, 2017)

There will be a few or alternate benefits and drawbacks that is related with it and should
be considered and for that it will be required that appropriate comprehension of them might be
attained. Some of them are clarified beneath:
Benefits:
 With the help of BEP, sales is pre- determined.
 The soundness in respect of propositions of firm would be understood and by this,
assistance is rendered to those who is seeking to invest or lend the money.
 The margin of safety is required to be identified that would be helpful in assessing the
point where the profits can be attained.
Drawbacks:
 As, BEP can exist in reality as the sales and the costs can not be the same.
 There are so many products made by the firm so the company cannot measure an
adequate BEP.
4. Simulation analysis:
Under the firm, there are two situations, that would be utilized and includes the condition
under which the information will be inadequate, and because of this, there will be vulnerability
under the firm. As, for this situation the data won't be accessible so examiner will not have the
capacity to convene appropriate examination and therefore recreation will be utilized
(Brinckmann, Salomo and Gemuenden, 2011).
The another circumstance under which it will embraced the point at which the cost s are
needed to be acquired would be low and furthermore the hazard engaged with the earth is less.
This can be said to be an experimentation technique in which no predetermined information is
accessible thus comes about are acquired on the premise of evaluations. In this all the numerical
esteems will be gathered and will be utilized and after that they will be utilized to direct the
investigation (Brigham and Houston, 2012). By this the possible results will be determined and
the activities which should be embraced.
This will be utilized as a part of basic leadership as by this it will be recognized what
exercises will be considered on need with the goal that the targets can be accomplished and task
can be finished in powerful way. There are different strides which would be taken after under
various things:

 Firstly, which should be utilized will be produced. The parameters will be set that should
be accomplished.
 The likelihood would be allocated to each factors which are irregular and for that outside
elements are mindful.
 Any esteem will be chosen on irregular basis for the forecasts that is made.
At that point net present esteem will be computed in regard of at that point and this will
be performed for every single other value and the best outcome will be chosen.
The benefits and drawbacks of it are as follows:
Advantages:
 Most of the inquiries will be replied on the premise of the predictions that are made.
 The information that is essential in this will be less with the goal that will be an
advantage.
 The costs which would be associated with this will be loe.
Drawbacks:
 The level of the suspicion associated with this would be high.
 There would be different political implications will be associated with this.
Hence, the greater part of the above are the required examination which should be attempted.
CONCLUSION
From the above report, it is outlined that capital budgeting is a group of various
techniques which is utilized by association for settling their money related issues. This task
throw a few lights on various appraisal systems which is particularly advantageous for
undertakings to limit their misfortunes by appropriate estimation process. Along these lines,
different strategies are analysed which goes under this report. These are sensitivity, scenario,
break even and scenario analysis Alongside this, it additionally featured use of these instruments
in planning process for procuring greatest advantage by considering significant raw numbers.
Finally, this report comprise of fundamental data which is utilized by back supervisors while
evaluating future cost.

REFERENCES
Books and journals
Brigham, E.F. and Houston, J.F., 2012. Fundamentals of financial management. Cengage
Learning.
Madura, J., 2011. International financial management. Cengage Learning.
Brinckmann, J., Salomo, S. and Gemuenden, H.G., 2011. Financial Management Competence of
Founding Teams and Growth of New Technology‐Based Firms. Entrepreneurship
Theory and Practice, 35(2), pp.217-243.
Andrews, M., 2011. Which organizational attributes are amenable to external reform? An
empirical study of African public financial management. International Public
Management Journal, 14(2), pp.131-156.
Sharan, V., 2012. International Financial Management. PHI Learning Pvt. Ltd..
Meng, X., Zhao, Q. and Shen, Q., 2011. Critical success factors for transfer-operate-transfer
urban water supply projects in China. Journal of Management in Engineering, 27(4),
pp.243-251.
Grinblatt, M. and Titman, S., 2016. Financial markets & corporate strategy.
Lusardi, A., 2012. Numeracy, financial literacy, and financial decision-making (No. w17821).
National Bureau of Economic Research.
Smit, Y. and Watkins, J.A., 2012. A literature review of small and medium enterprises (SME)
risk management practices in South Africa. African Journal of Business Management,
6(21), p.6324.
Schaeck, K. and Cihak, M., 2012. Banking competition and capital ratios. European Financial
Management, 18(5), pp.836-866.
Online
Break even analysis, 2017 [Online]. Available through:
<http://www.accountingformanagement.org/break-even-point-analysis/>. [Accessed on 18th
September, 2017]