Capital Budgeting Analysis

This report delves into the critical aspects of capital budgeting, emphasizing the importance of decision-making in management. It covers various methods such as Net Present Value (NPV) and Internal Rate of Return (IRR), along with techniques like sensitivity analysis, scenario analysis, breakeven analysis, and simulation analysis. Each method is explained in detail, highlighting its significance in evaluating investments and ensuring financial stability for firms. The report underscores the necessity of thorough analysis in corporate decision-making to avoid detrimental outcomes.

Capital budgeting
Management has the power of decision-making in its hand which gives it really important status
in a firm. Let it be a major decision or a minor decision, it is necessary for the management to
analyze the problem and make decisions in order to eliminate it. Any wrong decision by the
management will result in direct impact on the working of a company (Berman, Knight and
Case, n.d.). The wrong decisions will not only harm the firm in financial aspects but also it will
harm the reputation and status of the firm in the market which will make it difficult for the firm
to survive in the long run.
Decisions are made for every position on the level of the organization, that is, the top level,
intermediate level, and the lower level. It is really important for the firm to accept the decisions
of the management as it is very difficult to make decisions because the task of decision-making
is very complex (Bruner, Eades and Schill, 2017). In order to attain proper functioning of the
firm, there should be a sound relationship present between the management and the firm’s
employees. Capital budgeting is implemented by the management for making financial decisions
in a better manner so as to ascertain that no loss is suffered by the firm in near future.
Capital budgeting is the process of analyzing and evaluating all the expenses and investments of
the firm having huge amounts. There are certain examples which may help us to understand the
transactions which come under capital budgeting like, manufacturing of a plant and machinery or
investment in some long-term assets. This process takes into account current cash outflows at
present and future cash inflows to checks whether if the company is in the state of earning the
required rate of return. Therefore it is also called as “investment appraisal method” (Clarke and
Clarke, 1990).
As mentioned above that capital budgeting is a wide scope, there are several methods included in
it. The most important methods are the Net present values (NPV) and internal rate of return
(IRR). They may be explained as follows:
1.NPV: Net present value is evaluated by computing the difference between a number of
cash outflows and a number of cash inflows. This formula makes it easier to identify
the method of capital budgeting which can be used to know about the profits or loss
incurred and if gained or lost anything then what is the accurate value. A positive
NVP is considered to be better than the negative NPV which is considered to be
unfavorable (Fairhurst, 2015).
2.IRR- The internal rate of return (IRR) may be used to evaluate if the asset in which the
company is going to invest is favorable for its profit or not. If there is a case where all
the net present value of all cash flows is zero, then the interest rate is called IRR. It is
said to be advantageous when the IRR is greater than the required rate of return and is
disadvantageous when the IRR is less than the required rate of return.

3.The given example will help us to examine and understand the concept of IRR and
NPV in a much better way. The cash flows of two different projects are shown below:
All these methods were involved in order to perform the process of capital budgeting. There are
several different techniques of capital budgeting termed as Sensitivity analysis, Scenario
analysis, Breakeven analysis and Simulation analysis (Galbraith, Downey and Kates, 2002).
Sensitivity Analysis:
There are a lot of variables present; some of them are independent while others are dependent on
each other. Sensitivity analysis helps in analyzing the possible outcomes by using these
variables. After keeping some of the conditions unchanged, the changes in the dependent
variable caused due to changes in independent variables are evaluated by the analyst. Sensitivity
analysis may also be called as “What if analysis”. It is important to analyze even the smallest of
problems because it may cause a problem in future. Hence, we now know that how important is
it to take corporate decisions only after proper analysis. The name in itself says that even a small
variation in the inputs will be affecting the output when other factors are kept unchanged
(Hassani, 2016).
There are several steps that are needed to be carried out in order to perform sensitivity analysis:
1. There is supposed to be a base unit which will be used to compute the sensitivity of the
given data keeping other things unchanged.
2. It also helps to find the output value when all other values are kept unchanged except the
new level of output (Holland and Torregrosa, 2008).
3. The percentage change in income and output are required for the analysis.
4. Sensitivity analysis may be carried out by the formula- percentage change in output by
the percentage change in input.
From the above-mentioned steps it is clear that the higher the value of percentage change will be,
the more sensitivity figure will increase. Also, if the output is kept unchanged and the value of
percentage change in input decreases then also there will be a rise observed in the value of the
sensitivity figure (Khan and Jain, 2014).
Scenario Analysis:
This type of analysis helps to determine the “expected value” that may be received by an
investment in the future after a fixed time period when certain factors like the interest rate which
is changed (Palepu, Healy and Peek, 2016). It is an important task for the analyst to compare all
the investments present and choose the best alternative for its client so that it may help him earn
revenue in future. The market is dynamic in nature, so the returns on the portfolios are never
constant and change from time to time and thus this analysis helps in computing the extent of
changes. The investment is having a volatile nature which can be of high or low risk. This

analysis is thus helpful in determining the amount of risk factor a firm or a company is ready to
face (Phillips, 2014).
The standard deviation is calculated to know the level of risk and it is also taken as the variable
which may be used to compute the risk. The means of variables are used to calculate the
expected returns. Also, the possibility of changes in the portfolio may be computed using this
analysis (Reilly and Brown, 2012). There is a huge difference between the sensitivity and
scenario analysis which should be cleared before any calculation. Also, it should be noted that
the variables affect the computation of analysis in this case of sensitivity analysis.
Breakeven Analysis:
The main motive of every firm is to recover the cost and then incur profits. The situation where
the total cost of the firm equals total profit and the net income is valued zero is said to be the
breakeven point. According to financial aspects, it may be said that net income of the company
will be zero(Saltelli, Chan and Scott, 2008). A low breakeven point is good for the company
because it means that the company will incur good and timely profits. Sometimes confusion
between breakeven point and payback point arises. It should be cleared that payback point is the
time period in which the initial investment is to be returned whereas breakeven point is not
dependent on time but dependent on the amount of sales or units.
It can be further divided into two sub-categories:
1. Accounting Breakeven Analysis: the equation to define breakeven analysis is – Total
Revenue=Total Cost. It may be computed on the basis of the volume of sales or in terms
of units. The formula for the breakeven point is as follows:
Breakeven Point = (Fixed Cost + Depreciation) /Contribution Margin Ratio.
If depreciation will be excluded from the point then the result is known as cash breakeven
point (Saunders and Cornett, 2017) .
2. Financial Breakeven analysis: It is the point where the net present value of analysis is
zero and in such a case the cash flow is also at par with the initial investment.
Simulation Analysis:
Simulation means to imitate or pretend some action. This type of analysis is done in order to
compute the chances and meeting of different variables of a group. This action is considered to
be an important part of the capital budgeting process as it helps to find certain results which help
to make decisions regarding the investments (Shim and Siegel, 2008). There are also few
limitations which make it a bit hazardous like if we ignore some of the variables then the whole
analysis will become rouge and thus result in providing wrong information to the analyst.
These are several steps involved in this type of analysis:

1. Finding certain values or variable that affect the cash flows directly or indirectly.
2. Formulas for both simulation analysis and profitability distribution are stated together.
3. The distribution made is taken as a sample and the computer program chooses a random
variable and with the help of the variable net present value of the firm may be determined
n this step.
4. It will be observed that there is not a single value but there is a whole profitability
distribution as the result which shows all the expected and possible returns of the firm.

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