Capital Budgeting & Corporate Decision Making: Analysis Techniques

This report provides a comprehensive overview of capital budgeting techniques, including sensitivity analysis, scenario analysis, break-even analysis, and simulation analysis, and how they relate to corporate decision-making. It details how each technique is used to evaluate potential projects and investments, considering factors such as risk, cost, and potential returns. Sensitivity analysis focuses on identifying the effects of changing variables on a project's NPV, while scenario analysis evaluates outcomes under different realistic scenarios. Break-even analysis determines the minimum output required to avoid losses, and simulation analysis uses computer-based simulations to assess the probable outcome of multifactorial scenarios. The report concludes by emphasizing the importance of capital budgeting in making informed investment decisions, suggesting that businesses should choose the analysis method that best suits their specific circumstances and market dynamics to enhance their chances of achieving desired results. Desklib provides access to similar solved assignments and study resources.

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Capital Budgeting

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Contents
Overview:...................................................................................................................................3
a. Sensitivity analysis.................................................................................................................3
b. Scenario analysis....................................................................................................................5
c. Break-even analysis................................................................................................................6
d. Simulation analysis................................................................................................................7
Conclusion..................................................................................................................................9
References................................................................................................................................10

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Overview:
Capital Budgeting is a process that a business undergoes, to evaluate the upcoming projects
and investments. This process is set into practice to assess, whether, the upcoming project or
investment will be able to generate expected returns through various ways like throughput,
payback analysis and discounted cash flow. While evaluating, a business may consider the
cash inflow and outflow of the potential project or investment. This practice is also known as
Investment Appraisal. (Hayward, Caldwell, Steen, J., et.al, 2017)
In Capital Budgeting Analysis, the first and foremost step is to identify the opportunity and
then followed by analyzing the opportunity which takes into account various criteria to judge
the purposefulness of a project. Since, any business has limited resources, capital and time,
the capacity to take up projects or investments is also limited. To utilize their limited
resources, capital and time, businesses must choose the most beneficial investment plan
(Malenko, 2018). Hence, businesses evaluate the prospective projects through Capital
Budgeting and opt for the plan that promises them best returns over its lifetime.
a. Sensitivity analysis
Sensitivity analysis in Capital Budgeting Analysis is a method to determine the returns of a
potential project or upcoming investment by focusing on the variables. It forecasts the risk
that may be faced by the business in the future upon accepting a project (de Andrés de
Fuente, and San Martín, 2015). It considers individual input factors and foretells the outputs.
By changing the input determinants like sales revenue, competition, input revenue, etc.
Sensitivity Analysis tells what effects it will have on the outcome of the project (Marchioni,
and Magni, 2018). It assumes or predicts the unexpected factors before actually starting the
project and facing them. The sensitivity of a capital budgeting proposal can be determined by

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factors like level of revenues, the margin for operations, ratio of working capital requirements
to revenue and expected growth rate.
The purpose of Sensitivity Analysis in Capital Budgeting is to identify the effects on the NPV
of a proposal after subjecting to various changes in variables. It foretells the sensitivity or
vulnerability of an investment. Businesses that operate in turbulent markets have tough
competition, many rivals, variable sales, and other unexpected ups and downs must check the
sensitivity analysis of their capital budgeting proposals. It will help them predict the range of
fluctuation in the variables that are optimal for their business (Kengatharan, 2016). Also, it
will help to identify the most vulnerable factor that the business must keep a check while
executing the project.
A sensitivity analysis in capital budgeting is a useful method to check for weak spots in the
investment. The best kind of knowledge a business can possess is self-awareness. Knowing
own weak spots can not only help cease the universal problem of 'what are we doing wrong?'
but also help in allocating resources and monitors at the right places. Knowing about own
weaker areas will aid the management to critically evaluate every plan concerning its
usefulness to the respective aspects.
However, a sensitivity analysis works by varying a determinant and keeping others constant.
For instance, changes in price and sales go hand in hand and keeping one variable and
another constant for calculation sake will not gain real-time projections. Moreover, the
projections or results hence gained are evaluated based on experience and trends which may
not hold in the present since the market is a dynamic platform where the taste of the
consumer to the fiscal policies changes frequently. Post these negligence’s, sensitivity
analysis in capital budgeting is only a risk predicting method, not a risk-reducing method
which reduces its credibility significantly.

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b. Scenario analysis
Scenario Analysis, as the name suggests, is a process of evaluating the outcome of a project
by considering various scenarios. Here, the scenario stands for a set of determinants that can
cause an effect on the result of an action. However, these determinants should be realistic and
predictable like sales, price, etc., and unlike winning a lottery, death of the business owner,
etc. It is a strategic process of evaluating the decision by focusing on various other options at
hand too (De Souza, and Lunkes, 2016). Because of its working, this method is also known as
'alternative world's method. It does not predict the risks or challenges that a potential project
might face but acts like a tool to manage uncertainties.
In capital budgeting, scenario analysis considers three 'scenarios', namely, best-case scenario,
worst-case scenario, and base scenario. The base scenario is the expected return that the
business realistically expects from the project. The best-case scenario is a plan wherein
realistically favorable things happen to a business. Similarly, in the worst-case scenario,
realistically unfavorable circumstances fall upon the business which leads to poor returns. By
considering all the odds of the potential project, the business knows where to allocate
different kinds of resources for best results (Chittenden, and Derregia, 2015).
Scenario Analysis is a more inclusive way of evaluating the outcome of a potential project. It
does not predict statically by considering only one variable at a time rather sees all the
determinants together (AlKulaib, Al-Jassar, and Al-Saad, 2016). It also evaluates the
outcomes of the analysis according to present circumstances and not from the trends and
observations of the past. Scenario analysis also does not only predict the risk but it is a
process of selecting an approach towards the project by evaluating various approaches.
However, scenario analysis only takes into consideration a limited number of scenarios. A
business can't evaluate the huge number of actually possible scenarios that can take place.
Hence, scenario analysis is not accurate and precise and often the business will not run on the

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scenario that is decided with the help of this analysis. Secondly, scenario analysis
accumulates the best and worst kind of factors together to predict and choose the optimal
approach. However, in reality, it is not so. All the best and the worst scenarios do not club
together as a path, rather a mix of both kinds of scenarios come to play based on the manual
choices made by the business.
c. Break-even analysis
Break-even analysis in capital budgeting is a cost centric method to evaluate the utility of a
potential project. It focuses on the fixed costs, variable costs and returns and studies the
relationship between them. The term 'break-even' refers to the point wherein the ratio of all
costs tends to yield positive returns. In other words, the break-even price will be a price that
would cover all the production costs and give desirable profit to the business (Batra and
Verma, 2017).
The main purpose of break-even analysis is to evaluate the least output required to save the
business from facing any losses. It is an analytical tool that does not predict, rather suggests
and keeps a firm from opting for a project that might require much cost and yield less profit
(Doss et.al, 2015). It suggests a volume to be produced at a fixed price to break even all
expenses by the company. Even if the business cannot produce that number then also it
suggests reducing the fixed and variable costs by a certain value to break even in the existing
output limit.
Break-even analysis in capital budgeting is beneficial as it suggests the relationship between
costs, returns, and production volumes. Using this data and relationship, any business can
calculate the price and volume which will give the most utility to their cost. Also, by
manipulating this data, by changing the relationship between fixed cost and variable cost,

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fixed price, and variable price, or, fixed revenue and variable revenue, a business can control
the profit levels. Moreover, this process can determine the minimum business requirements to
incur no loss.
However, the break-even analysis limits the business in more than one way. This approach is
best suited for analyzing only one product at a time. Moreover, while analyzing a single
product, even then it is difficult to determine a cost as wholly fixed or fully variable.
Furthermore, a business may have the will to use the breakeven price and incur more profit
even when the income and cost functions have changed. This process is useful for partial
budgeting only (De Souza, and Lunkes, 2016).
d. Simulation analysis
Simulation Analysis or the Monte Carlo Simulation Analysis is a method to find out the
probable outcome of a multifactorial scenario (De Souza, and Lunkes, 2016). Contrary to the
Scenario analysis, it runs many scenarios parallel in keeping in light the multiple possibilities
and distribution of all the affecting input factors. As a result, all the input factors project a
probable output. It undertakes all the possibilities and distribution of input factor and how
they can impact the output.
Simulation analysis is beneficial in capital budgeting as it simulates a real-life situation. A
business can create a digital simulation of its proposed project and run a real-life simulation
to know how it will perform. Hence, making a better judgment on validating or accepting a
plan for own business. Even if the simulation does not state desirable results, the management
can always know the weaker areas and strong points of the business plan and run another
improvised simulation.
Simulation analysis in capital budgeting is the most efficient and precise way of appraising an
investing or evaluating a potential project. As it considers all the infuriating factors in a

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dynamic system and simulates their working in real life it gives the most precise estimate of
returns and knowledge of all the performance dragging and uplifting factors. It provides the
business with realistic feedback when developing a real-world product. Moreover, it lessens
the manual efforts and brainstorming as this method is an entirely computer-based approach
(Kozlova, Collan, and Luukka, 2017).
However, with the advantages of simulation analysis in capital budgeting, there are a couple
of disadvantages that make it inaccessible. The simulation of a model can be very expensive
and not every business can afford to spend a hefty amount of money on appraisal itself.
Simulation analysis, hence, is only suited for big projects and big businesses, making it a
non-universal approach. The building of simulation is an expensive affair but the
conductance of stimulation requires equal amounts of money (Regan, et.al, 2015). Moreover,
the results thus gained upon running a simulation are not easy to interpret. It requires
expertise to interpret those results, which if not done properly, fail the entire process and risk
a hefty amount of money.
Capital budgeting is an essential part of a business plan. It acts as the foundation of the
project on which it is supposed to be built. If the foundation is laid programmatically on
strong ground, the building is meant to fall. Likewise, capital budgeting or appraisal of
investment is equally important. If the plan for the potential project is unchecked, there is
very less probability that the project will prosper. However, if the plan is checked using real-
life tools and techniques and the test passes those criteria, the business can be hopeful for
actually achieving the desired result.
Conclusion
Capital budgeting can be done in various ways, depending upon the circumstances. If the
business is located in a very dynamic market with many rivals, the business may opt for
sensitive analysis for capital budgeting. If the business is a traditional one i.e., being done

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over the years, the business may opt for scenario analysis in capital budgeting. However, if
the business is cost and volume centric i.e., a business of commonly used products, the
business may opt for break-even analysis. And, if it is a large scale business and wants to set
a foot in the market, it might as well go for simulation analysis. However, a business may run
the plan through every analysis, because in the end, a capital budgeting or investment
appraisal should only help the management to make a better decision and keep it from facing
any shocks.

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References
AlKulaib, Y.A., Al-Jassar, S.A. and Al-Saad, K., 2016. Theory and practice in capital
budgeting: evidence from Kuwait. Journal of Applied Business Research (JABR), 32(4),
pp.1273-1286.
Batra, R. and Verma, S., 2017. Capital budgeting practices in Indian companies. IIMB
Management Review, 29(1), pp.29-44.
Chittenden, F. and Derregia, M., 2015. Uncertainty, irreversibility and the use of ‘rules of
thumb capital budgeting. The British Accounting Review, 47(3), pp.225-236.
de Andrés, P., de Fuente, G., and San Martín, P., 2015. Capital budgeting practices in Spain.
BRQ Business Research Quarterly, 18(1), pp.37-56.
De Souza, P. and Lunkes, R.J., 2016. Capital budgeting practices by large Brazilian
companies. Contaduría y Administración, 61(3), pp.514-534.
De Souza, P. and Lunkes, R.J., 2016. Capital budgeting practices by large Brazilian
companies. Contaduría y Administración, 61(3), pp.514-534.
Doss, D.A., Jones, D.W., Sumrall, W., Henley, R., McElreath, D., Lackey, H. and Gokaraju,
B., 2015. A net present worth analysis of considered academic programs at a private, regional
higher education institution. Journal of Interdisciplinary Studies in Education, 4(1), pp.55-
77.
Hayward, M., Caldwell, A., Steen, J., Gow, D., and Liesch, P., 2017. Entrepreneurs’ capital
budgeting orientations and innovation outputs: Evidence from Australian biotechnology
firms. Long Range Planning, 50(2), pp.121-133.
Kengatharan, L., 2016. Capital budgeting theory and practice: a review and agenda for future
research. Applied Economics and Finance, 3(2), pp.15-38.

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Kozlova, M., Collan, M. and Luukka, P., 2017. Simulation decomposition: New approach for
better simulation analysis of multi-variable investment projects.
Malenko, A., 2018. Optimal dynamic capital budgeting. Available at SSRN 1710884.
Marchioni, A. and Magni, C.A., 2018. Investment decisions and sensitivity analysis: NPV-
consistency of rates of return. European Journal of Operational Research, 268(1), pp.361-
372.
Regan, C.M., Bryan, B.A., Connor, J.D., Meyer, W.S., Ostendorf, B., Zhu, Z. and Bao, C.,
2015. Real options analysis for land use management: Methods, application, and implications
for policy. Journal of environmental management, 161, pp.144-152.