Corporate Finance: Capital Budgeting Analysis Report

This report delves into the core concepts of capital budgeting within corporate financial management. It provides a comprehensive analysis of several key techniques used in investment decision-making. The report begins with an introduction to capital budgeting and its importance, followed by an in-depth examination of sensitivity analysis, which assesses how changes in variables affect Net Present Value (NPV) and Internal Rate of Return (IRR). The report then explores scenario analysis, evaluating investment values under different situations and their probabilities. Next, it covers break-even analysis, determining the point where costs equal revenues, and its application in setting sales targets. Finally, the report discusses simulation analysis, a method used when data is sparse and uncertainty is high, employing random variables to forecast potential outcomes. The report concludes by summarizing the benefits of these techniques in minimizing financial risks and aiding effective decision-making in capital budgeting.

Corporate financial
management

Table of Contents
INTRODUCTION...........................................................................................................................1
TASK ..............................................................................................................................................1
1. Sensitivity analysis.................................................................................................................1
2. scenario analysis......................................................................................................................2
3. Break even analysis.................................................................................................................3
4. Simulation analysis.................................................................................................................4
CONCLUSION................................................................................................................................5
REFERENCES................................................................................................................................7
.........................................................................................................................................................7

INTRODUCTION
In the process of making decisions there are various tools which are used and for them
analysis will have to be conducted (Arnold, 2013). There are several such ways by which it can
be done. All the projects which will be present will be evaluated on the basis of the various
techniques and the data which will be collected with the help of analysis. In this report, manner
in capital budgeting will be undertaken will be explained with the use of various important
techniques.
TASK
1. Sensitivity analysis.
Capital budgeting is the process in which the decisions will be made in respect of any
investment which will have to be made. For this the consideration will be given to various
aspects which are uncertainty and risk. The variance will be there in the amount which were
estimated and the actual results and by that risk will be increased (Brigham and Houston, 2012).
There are various assumptions which are made and the manner or the level in which NPV will
be affected by change in them will be determined with the help of sensitivity analysis. By the
use of this the change in the variable factor on net present value or internal rate of return will be
determined. By the use of this analysation will be made in advance in respect of the project
which is being considered to be undertaken. The risk which will be present in that will be
identified and that way management will be able to make the best decisions by which the project
which will be providing with the maximum returns will be used. The main object of capital
budgeting will be fulfilled with the help of it.
In order to conduct it in the best way it will be needed that all the steps which are
specified in this regard shall be followed which will be involving following:
 In respect of variables, estimates will be made which will be used to arrive at a certain
decision.
 The level upto which estimates can fluctuate will be identified by analysing all the
selected variables.
 Further examination will be made so that changes of any wrong can be determined.
 All the variation which will be found will be recorded in form of percentage.
1

By using the above mentioned process, the benefit will be received by the company as it will be
saved from the loss which will have to be otherwise borne (Brigham and Ehrhardt, 2013). There
are various advantages and disadvantages which are related to it and are provided here under:
Advantages:
 The most important assumption which are made will be identified.
 This will be helpful in the identification of risk which will be used to make preparation to
deal with them.
 The process involved in forecasting will become more robust by this.
Disadvantages:
 The results will only be good when the data which will be used will be proper.
 At a point of time only one assumption will be tested.
 It is difficult for the managers to understand it as the process involved in this is complex.
So all of the above mentioned aspects will have to be considered while performing the
analysis which will be beneficial in making decisions.
2. scenario analysis.
In an organisation there are various activities which will have to be undertaken and in
respect of them it will be required that the value of the investment which will have to be made
will be identified (Brealey, Myers and Mohanty, 2012). For this different situations will be there
and the combination of them will be prepared by taking their probability under consideration. By
the help of this the value will be identified and probability of occurrence of that particular group
will also be derived.
This will be telling about the risk which will be involved in the investment. The decision
will be made in relation to it by making a comparison of risk which is expected with the expected
return to be earned. Also the tolerance level of the investors will be considered in this which will
be beneficial to make the correct decision. By the analysation of the various situations all the
possible outcomes which can be gained will be determined. The manner in which the issues that
will be arising can be dealt will also be set as prior information will be available in respect of
them.
In order to carry out the procedure in appropriate manner it will be required that all the
advantages and disadvantages shall be known so that proper plan can be made to overcome them
(Brigham and Daves, 2012).
2

Some of them are provided below:
Advantages:
 By this a range of results will be provided and the best among all will be selected.
 Managers will be using the output for various reasons which are determination of NPV
and deviation which can be expected.
Disadvantages:
 There are some of the discrete outcomes to which it will be limited.
 In this it is assumed that there will be perfect correlation between the inputs of the best
and worst case variables.
 By this a clear decision cannot be made in respect of the proposal to be accepted or
rejected.
These are the points which will be noted by the organisation so that all the advantages
can be used for the benefit of the business. By them the capital budgeting will be made possible
as it will be identified that which will be the project combination that can be selected and prove
to be of great help.
3

Illustration 1: scenario analysis
(Source: Scenario Analysis, 2017)
3. Break even analysis.
In the project that will be undertaken there will be some or the other incomes and cost
which will have to be incurred. In this analysis it will be identified that what will be the point at
which they both will be equated (Chandra, 2011). This means that level of activities at which the
company will be having neither profits nor losses. Margin of safety will be calculated with the
help of this that will be that point at which the sales of the company will be more in respect of
the break even point. In this method only the cost involved in sales will be analysed so due to
this reason it is known as supply side analysis. The change in the demand due to price change
will not be determined in this method so the aspect in respect of the customers needs will not be
undertaken in this.
This will be of great help in the capital budgeting as by this decision will be made in
respect of the level of ales which will have to be maintained by the organisation so that desired
level of profits can be attained. There are various costs which will be involved in the production
of any product and can be classified in variable and fixed cost. The amount of the fixed cost will
4

be the one that will have to be incurred in all the situations and will not be fluctuating with the
change in the level of production.
The manner in which this will be calculating will be involving determination of the
contribution which will be made on the per unit (Higgins, 2012). It will be derived by reducing
the amount of variable cost from the selling price which will be decided in respect of nay
product. Then fixed overheads will be divided by that amount and the level of break even
quantity will be determined. The decision will be made on the basis of it. It will be decided that
if the volume will be above the break even point then that will be accepted otherwise it will have
to be rejected. The company will have to make such policies by which all the shortcomings will
be overcome will be identified. They will be used so that all the desired outcomes which are
predefined can be achieved.
There will be some or the other merits and demerits that will eb associated with it and
will have to be taken into consideration and for that it will be needed that proper understanding
of them shall be obtained. Some of them are explained below:
Advantages:
 it will be identified in advance that what will be the amount of sales which will have to be
made.
 The viability in respect of propositions of business will be understood and by this help
will be provided to those who want to invest or lend the money.
 The level of margin of safety will be identified which will be helpful in knowing the
point at which loss will be incurred.
Disadvantages:
 as it is not possible that the sales and the output will be same so it will be a demerit.
 The product which are made by company are many and so it will not be possible to
calculate the correct break even point.
4. Simulation analysis
In the business there are two cases in which it will be used and that will be involving the
condition in which the data will be sparse and due to this there will be uncertainty in the business
(Altman and Hotchkiss, 2010). As in this case the information will not be available so analyst
will not be able to conduct proper examination and for this reason simulation will be used.
5

The another situation in which it will be undertaken will be when the cost that will be
required to be incurred will be low and also the risk involved in the environment is less. This can
be said to be a trial and error method in which no specified data is available and so results are
obtained on the basis of estimates. In this all the numerical values will be collected and will be
used and after that they will be used to conduct the analysis. By this the probable outcomes will
be ascertained and the actions which will have to be undertaken.
This will be used in decision making as by this it will be identified that which activities
will be considered on priority so that the objectives can be achieved and project can be
completed in effective manner (Ling and Archer, 2012). There are various steps which will be
followed under this and that will be :
 Firstly model which will have to be used will be developed. The parameters will be set
that will have to be achieved.
 The probability will be assigned to all the variables which are random and for that
external factors are responsible.
 Any value will be selected on random basis out of the distribution which is made.
 Then net present value will be calculated in respect of then and this will be performed for
all other values and the best result will be selected (Aebi, Sabato and Schmid, 2012).
The merits and demerits of it are as follows:
Advantages:
 Many questions will be answered on the basis of the forecasts which are made.
 The data which would be required in this will be less so that will be a benefit.
 The cost that will be involved in this will be loe.
Disadvantages:
 the level of the scepticism involved in this will be high.
 There will be various political implications will be involved in this.
So all of the above are the required analysis which will have to be undertaken.
CONCLUSION
From the above report it can be summarized that capital budgeting is a cluster of
numerous methods which is used by organization for resolving their financial problems. This
assignment throw some lights on different assessment techniques which is very much beneficial
for enterprises to minimize their losses by proper estimation process. Therefore various
6

methodology which comes under this report are sensitivity, simulation, break-even as well as
scenario analysis. Along with this, it also highlighted usage of these tools in budgeting process
for acquiring maximum benefit by considering relevant facts and figures. Lastly, this report
consist of necessary information which is used by finance managers while estimating future cost.
7

REFERENCES
Books and Journal
Arnold, G., 2013. Corporate financial management. Pearson Higher Ed.
Brigham, E.F. and Houston, J.F., 2012. Fundamentals of financial management. Cengage
Learning.
Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage
Learning.
Brealey, R.A., Myers, S.C., Allen, F. and Mohanty, P., 2012.Principles of corporate finance.
Tata McGraw-Hill Education.
Brigham, E. and Daves, P., 2012.Intermediate financial management. Nelson Education.
Chandra, P., 2011. Financial management. Tata McGraw-Hill Education.
Higgins, R.C., 2012.Analysis for financial management. McGraw-Hill/Irwin.
Altman, E.I. and Hotchkiss, E., 2010. Corporate financial distress and bankruptcy: Predict and
avoid bankruptcy, analyze and invest in distressed debt (Vol. 289). John Wiley & Sons.
Ling, D. and Archer, W., 2012. Real estate principles: A value approach. McGraw-Hill Higher
Education.
ONLINE
Financial Management - Meaning, Objectives and Functions. 2017. Available
through<http://www.managementstudyguide.com/financial-goal.htm>. [Accessed on
26th August 2017]
8