Risk Management Analysis: Techniques in Capital Budgeting Decisions

This report provides a detailed analysis of various capital budgeting techniques used for project planning and risk management. It begins by introducing capital budgeting and its importance in evaluating large investments, emphasizing the critical analysis of risks and returns. The report then delves into specific techniques, including sensitivity analysis, which examines the impact of key variable deviations on project feasibility. Simulation analysis is discussed as a method to assess risk using mathematical models and random scenarios. Breakeven analysis, used to determine sales levels needed to cover business costs, is also explored, along with its assumptions and applications in decision-making. Finally, scenario analysis is presented as a tool to estimate investment portfolio values under different conditions, focusing on identifying best and worst-case scenarios. The report concludes by highlighting the advantages and limitations of each technique, underscoring the need for project managers to apply their skills and knowledge in interpreting the analysis results.

RUNNING HEAD: RISK MANAGEMENT ANALYSIS
TECHNIQUES OF
CAPITAL
BUDGETING

RISK MANAGEMENT ANALYSIS 1
Table of Contents
Introduction................................................................................................................................2
Sensitivity Analysis....................................................................................................................2
Simulation Analysis...................................................................................................................4
Breakeven Analysis....................................................................................................................5
Scenario Analysis.......................................................................................................................7
Conclusion..................................................................................................................................9
References................................................................................................................................10
APPENDICES..........................................................................................................................11
Table of Figures
Figure 1 Sensitivity Analysis of Project’s NPV.......................................................................11
Figure 2 Monte Carlo Simulation of Equity Trading...............................................................11
Figure 3 Simulation Analysis of project's risk and return factors............................................12
Figure 4 Breakeven Analysis...................................................................................................12

RISK MANAGEMENT ANALYSIS 2
Introduction
Capital budgeting is an important technique used for the purpose of project planning. It
involves evaluation of large investments as it requires deployment of huge funds to start a
project. The overall profitability of all the alternative plans is considered to make an
investment in the project. The risks and the returns on the investments are critically analysed
and based on which rankings are allotted to each and every potential project plan. To make an
assessment of risks involved in a particular project different techniques can be used such as
sensitivity analysis, simulation analysis or the scenario analysis. These techniques are
explained below in details.
Sensitivity Analysis
Sensitivity analysis is also called as “What-If analysis”. This is an important technique used
in capital budgeting as it enables the project manager to determine the project’s feasibility if
some of the key variables out of the entire set of input parameters such as sales, variable cost,
life of the asset, discounting factor etc. gets deviated from the expected value (Gotze,
Northcott & Schuster, 2016). In capital budgeting, decisions regarding whether to invest in a
particular project plan or not depends upon the Net Present Value of the total cash flows of
the project therefore sensitivity analysis is done in NPV terms (Cao & Wan, 2017).The
analysis is carried by making a change in one variable while holding the other variables as
constant. Technique of sensitivity analysis is widely used by the project managers for the
reason that it helps in examining the sensitivity of a project to the changes in input variables
(Edmans, Jayaraman & Schneemeier, 2017). Following are some of the key uses of the above
explained technique:

RISK MANAGEMENT ANALYSIS 3
 Helpful in making relevant and significant decisions.
 This tool aids to understand the project’s behaviour if there are variations in the key
areas.
 It also helps to assess and analyse the risk involved in any business plan or strategy.
 It compels the project manager to identify the key variables which can affect the cash
flow level.
Despite of many uses, sensitivity analysis proves to be an unreliable tool of capital budgeting
in certain circumstances.
 Information not decision: The technique of sensitivity analysis provides the users with
the information for capital budgeting decisions but it does not provide the actual
decision which managers requires to take( Ross et al., 2010).
 Focus on variables not their probability: Sensitivity analysis only keeps it focus on the
key parameters that may get deviated from the expected values but does not determine
the probability of occurrence of those variations (Saltelli, 2007).
 Unreasonable assumptions: this analysis is based on the assumption that the key
variables are independent of each other, when in actual life they are not.
Simulation Analysis
This method is used to analyse the risk involved in business while making capital budgeting
decision with the help of a logical and mathematical model. It uses a series of random but
related situations which are possible if there occurs some variations (Baker & English, 2011).
Simulation techniques helps in representation of actual decision making under different
situations so as to identify the possible courses of action. This tool provides a reasonable
method to reach at an appropriate decision while dealing with the real world managerial

RISK MANAGEMENT ANALYSIS 4
situations which are complex enough to be solved. This tool has its own pros and cons which
are as follows:
Pros
 The simulation technique avoids the rigidity factor as it can adjusted to incorporate
several variations in the processes.
 It helps in strategic planning for any business
 The hit and trial runs conducted under this technique avoids the need of
experimenting the ideas on new equipment and machineries.
 This technique is easier than the other decision making problems.
Cons
 This technique does not provide accurate solutions.
 It is not suitable for all the real business problems.
Simulation does not offer an optimum solution to the concerned problem but it seek to
provide the possible range of outputs for the given inputs (Chiarella & Iori, 2002). While
using this method the project managers observes the behaviour of the processes
experimenting different trial & error runs in the same way as they would observe if they had
worked on the real problems (Tavare, 2013).
Simulation method basically uses two types of models to carry the process of simulation and
those models are as follows:
 Mathematical model: This model uses the numeric values and equations for the
representation a real problem. This model has further bifurcations:
 Deterministic Model: This is used when the exact functional relationship between
the inputs and outputs is given. This model actually caries the what if analysis.

RISK MANAGEMENT ANALYSIS 5
 Probabilistic Model: this model is also known as stochastic model and is used in the
case of random variations (Choe, 2016) (Lima, et al., 2017).
 Physical Model: This model uses physical inputs to test the performance. Like use of
prototype model of airplane to determine the characteristics of aerodynamics
(Suryani, et al., 2010). This model is expensive enough and therefore need not to be
applied to each situation.
The most common method of simulation technique is the Monte Carlo method as it a
numerical tool used to determine the results of different inputs for a given situation relating to
the business of manager. The inputs are given in the form of series of random numbers with
different probabilities of occurrence.
Breakeven Analysis
This analysis entails the determination of level of sales a business is required to achieve in
order to cover the cost of conducting the business. This analysis is undertaken to make
decisions regarding the price fixation of products manufactured by the company. It explains
the dynamic relation between the three main factors of any business, i.e. sales, profit and the
total cost and hence it is also called as cost-volume-profit analysis (Gutierrez & Dalsted).
Breakeven point is the level of sales where the revenues generating from the business meets
the total costs of business, leaving the net income as zero.
This is situation where company neither attains any profit nor incurs any losses. The finance
manager is mainly concerned about this concept as it is very useful in forecasting of profits of
the business and the impact of alternative courses of action in business management
(Tsorakidis, 2011).

RISK MANAGEMENT ANALYSIS 6
To conduct the break even analysis break even charts are being used by the management
accountants which indicates the relationship of total variable cost, total fixed cost, total cost
and the total revenues of the company. There are certain assumptions on the basis of the
critical analysis of breakeven point of sales is undertaken. Following are some of those
assumptions:
 It does not consider semi variable costs. This analysis assumes only fixed and the
variable costs as business costs.
 The product price is assumed to remain same.
 Sales and production volume of the business are assumed to be same.
 It also assumes that the variable cost increases with the production at a constant rate.
 The technology used in production and the efficiency of labour remains constant.
The importance of breakeven analysis is that it offers presentation of every minute picture
of the structure of profit of any business. This analysis also aids business managers in
keep sharp focus on the leverages which can affect the profitability of business.
Prime use of breakeven analysis:
 Determination of margin of safety: margin of safety is the level up to which an
organisation can accept decline in its sales before it starts making losses. So break
even analysis helps the management in determining the level of profit it generates at
different level of sales.
 Decision making regarding Make or Buy issues: The analysis assists a firm in deciding
whether it will be profitable for it to manufacture a product or to buy it from outside
market by identifying the breakeven point.
 Selection of production technique: Breakeven analysis is the simplest way to decide
about the deployment of techniques which are most suitable as for lower levels of

RISK MANAGEMENT ANALYSIS 7
sales, traditional methods can be used and for higher levels of sales advanced machines
may be required. This analysis may help by indicating the costs of alternative
production techniques.
Despite of several uses of the breakeven analysis there are still some of the issues which
makes the analysis ineffective. They are as follows:
 While analysing everything such is kept constant whereas in practical situation it is
not so.
 Breakeven analysis ignores the non-financial factors such as changes in the
technology, management style improvements etc. as it only considers level of output
as the reason for profit.
 Ignorance of taxations in this analysis also makes it unsuitable for the corporates
which have higher tax obligations.
 As it is primarily based on accounting data which may not be accurate enough to take
decisions so it becomes unreasonable to use this technique.
Scenario Analysis
This analysis is used to estimate the anticipated value of a portfolio of investments at the end
of a particular period. As from the above research it can be demonstrated that the sensitivity
analysis deals only with the variation of only one parameter at a time to observe the impact
on profitability of the company as a result of the change (Kalyebara and Islam,
2014).However, to critically analyse the risk, change in more than one variable must be
considered at a time so as to examine the overall behaviour of project’s outcome. Scenario
analysis helps in providing the aid to the above issue. This technique basically emphasises on

RISK MANAGEMENT ANALYSIS 8
identifying the extent to which the project can turn down in the worst scenarios. Also, it seek
to identify the worst and the best case scenarios in order to consider the entire range of
possible results (Erdmann & Hilty, 2010). To reach the the worst and best scenarios the
analysis starts with the base case. This technique of analysing the scenarios is used to
estimate the changes in the value of portfolio as a result of occurrence of unfavourable
events. The scenarios that are considered in this analysis can be in relation to a unique
variable like a success or failure factor of a project plan or several factors in combination for
example project results in combination of changes in the technologies or consumer tastes and
preferences (Xuan & Yue, 2017).
Although the simulation analysis seems to be simple enough, it requires some critical
functions to be undertaken to carry out the analysis:
 The identification of factors based on which the set-up of scenarios will be made. The
factors may vary from firm to firm.
 Determination of number of case scenarios to analyse each factor. In general three
scenarios are used which are the best, average and the worst case scenario.
 Placing emphasise on the most critical factors.
 Allocation of probabilities to each and every scenario that was built at the earlier
stage.
Scenario analysis provides the extended solutions to the risk analysis in comparison to the
sensitivity analysis. Rather than considering the sensitivity of a project to the variability of
input parameters, the scenario analysis also focuses on the distribution of probability to
different variables. These probabilities are allocated to the scenarios to calculate the expected
value.

RISK MANAGEMENT ANALYSIS 9
Conclusion
From the above research it can be concluded that all the capital budgeting techniques possess
their own advantages but still suffers some limitations which makes them unreasonable to be
applied by the project managers in certain situations. A project manager needs to apply
requisite skills and knowledge to conduct the analysis under the above explained techniques.
As these techniques of capital budgeting does not provide the managers with the firm
decision they are required to interpret the information provided by the analyses. However, the
case of breakeven analysis is slightly different as it provides the exact results the company
must achieve in order to cover the total costs. Breakeven charts are also easy to interpret the
desirable targets which are to be achieved.
-

RISK MANAGEMENT ANALYSIS 10
References:
Baker, H. and English, P., 2011. Capital Budgeting Valuation. Somerset: Wiley.
Cao, X.R. and Wan, X., 2017. Sensitivity analysis of nonlinear behavior with distorted
probability. Mathematical Finance, 27(1), pp.115-150.
Chiarella, C. and Iori, G., 2002. A simulation analysis of the microstructure of double auction
markets*. Quantitative finance, 2(5), pp.346-353.
Choe, G. H., 2016, Stochastic Analysis for Finance with Simulations, Springer International
Publishing, Switzerland.
De Lima, J.D., Trentin, M.G., Oliveira, G.A., Batistus, D.R. and Setti, D., 2017. Systematic
Analysis of Economic Viability with Stochastic Approach: A Proposal for Investment.
In Engineering Systems and Networks (pp. 317-325). Springer, Cham.
Edmans, A., Jayaraman, S. and Schneemeier, J., 2017. The source of information in prices
and investment-price sensitivity. Journal of Financial Economics.
Erdmann, L. and Hilty, L.M., 2010. Scenario analysis. Journal of Industrial Ecology, 14(5),
pp.826-843.
Gotze, U., Northcott, D. and Schuster, P., 2016. INVESTMENT APPRAISAL. Springer
International Publishing, Berlin.
Gutierrez. P. & Dalsted, N., n.d, Break-Even Method of Investment Analysis, Colorado State
University, available at < http://extension.colostate.edu/docs/pubs/farmmgt/03759.pdf >
(viewed on 15-09-2017).

RISK MANAGEMENT ANALYSIS 11
Kalyebara, B. and Islam, S., 2014. Corporate Governance, capital markets, and capital
budgeting. Dordrecht: Physica-Verlag.
Ross, S., Traylor, R., Bird, R., Westerfield, R. & Jordan, B., 2010. Essentials of corporate
finance, edn 2nd, McGraw-Hill Education.
Saltelli, A. 2007, Sensitivity analysis in practice. Chichester: John Wwiley and Sons.
Suryani, E., Chou, S.Y., Hartono, R. and Chen, C.H., 2010. Demand scenario analysis and
planned capacity expansion: A system dynamics framework. Simulation Modelling Practice
and Theory, 18(6), pp.732-751.
Tavare, N.S., 2013. Industrial crystallization: process simulation analysis and design.
Springer Science & Business Media.
Tsorakidis, N., Papadoulos, S., Zerres, M. and Zerres, C., 2011. Break-Even Analysis.
Bookboon.
Xuan, Y. and Yue, Q., 2017. Scenario analysis on resource and environmental benefits of
imported steel scrap for China’s steel industry. Resources, Conservation and Recycling, 120,
pp.186-198.
APPENDICES

RISK MANAGEMENT ANALYSIS 12
SENSITIVITY ANALYSIS
Figure 1 Sensitivity Analysis of Project’s NPV
SIMULATION ANALYSIS
Source: http://www.knispo-guide-to-stock-trading.com/monte-carlo-simulation.html
Figure 2 Monte Carlo Simulation of Equity Trading
SIMULATION ANALYSIS

RISK MANAGEMENT ANALYSIS 13
Risk Return
0%
5%
10%
15%
20%
25%
Scenario Analysis
WORST NORMAL BEST
Cases
Risk & Returns
Figure 3 Simulation Analysis of project's risk and return factors.
BREAKEVEN ANALYSIS
Figure 4 Breakeven Analysis