Risk Analysis in Capital Budgeting Techniques

Running Head: Risk Analysis in Capital Budgeting
Capital Budgeting
Techniques

Risk Analysis in Capital Budgeting 1
Table of Contents
Introduction........................................................................................................... 1
Sensitivity Analysis................................................................................................ 2
Scenario Analysis................................................................................................... 2
Break-even Analysis.............................................................................................. 3
Simulation Analysis................................................................................................ 4
Practical analysis of capital budgeting techniques................................................5
Sensitivity analysis............................................................................................. 5
Scenario analysis................................................................................................ 6
Breakeven analysis............................................................................................. 7
Simulation analysis............................................................................................. 9
Conclusion............................................................................................................. 9
References........................................................................................................... 10

Risk Analysis in Capital Budgeting 2
Introduction
Capital Budgeting is the most important constitute of financial management as it involves
decisions making about the capital expenditures to be made under any project. As these
projects requires the deployment of huge funds for a long term, project managers must study
each and every element of project in details. Capital budgeting covers the critical analysis of
project and all the alternative project plans considering various factors such as risk and return
factor, the discounting rate, the technological and environmental factors, the initial
investment requirements etc. While selecting a project, the project manager has to analyse
and access the key variations that may occur in future while undertaking the project and
comprehensively examine the project’s behaviour in terms of profitability. For all the project
planning decisions there are various techniques and analyses available in today’s world which
are advanced enough to understand the changes in the output that may be occurred due to
input variations. These techniques are sensitivity analysis, simulation analysis, scenario
analysis, breakeven analysis etc. The detailed discussion on such capital budgeting technique
is given below:
Sensitivity Analysis
This technique is the most commonly used capital budgeting technique while making project
planning decisions. The sensitivity analysis helps the managers to analyse the change in the
project output with the changes in the key input variables (Saltelli, 2007). The basic purpose
of using this approach is to examine the sensitivity of any project in terms of Net Present
Value (Cao & Wan, 2017). There is no inclusive list of variable input parameters but there
can be factors like interest rates, useful life of asset, the fixed cost, variable cost per unit,
selling price or the number of units to be sold, residual value estimations etc. that may get
changed frequently over the life of project (Edmans, Jayaraman, Schneemeier, 2017). Before
investing the huge amount of funds in any project plan the firm must identify the significant
parameters that may undergo changes if the assumptions goes wrong. Once the key variable
factors are identified the project manager must determine the percentage change in the NPV
of the project if the input factors changes with a certain percentage.

Risk Analysis in Capital Budgeting 3
Sensitivity analysis is also known as ‘what-if’ analysis (Baker & English, 2011). This
analysis has its own advantages and at the same time it has some limits which makes it
unreasonable in certain situations. Following are some of the advantages and disadvantages
of sensitivity analysis:
Advantages:
 It enables the project managers to identify the key parameters which may impact the
future cash flows of the project.
 It helps in analysing the cause and effect of variations in the input parameters thereby
enabling the managers to take appropriate actions to control them and to plan the
future course of actions for the uncertainties.
 The risk involved in the capital budgeting decisions can be analysed to a certain
extent using this approach.
Disadvantages:
 This technique does not provide managers with the firm decision rather it provides the
relevant information that can be used in decision making.
 The assumptions that the variables are not dependent on each other is not reasonable
in maximum situations.
 The probability consideration of occurrence of variations is lacking in the sensitivity
analysis.
 The project managers while undertaking the sensitivity analysis bases his assumptions
for the budgeting and forecasting purpose on three approaches that are optimistic
pessimistic and expected.
Scenario Analysis
One of the most common way of analysing the risk involved in the investment to be made by
the firm is the scenario analysis (Kalyebara & Islam, 2014). Under this methodology the firm
calculates the NPV of a project considering several scenarios. The scenarios that are
considered under the scenario analysis are based on optimistic pessimistic and expected
mind-sets. The analysis initiates with the consideration of base case scenario. The project
NPVs are calculated using the base case scenario firstly and then the other possible scenarios
are selected. There is no limit of numbers of scenarios a firm must consider while evaluating