FIN200 Corporate Financial Management

Describe the Management of a company could use sensitivity, scenario, break-even and simulation techniques/analysis in their corporate decision makings. How management decision making could be related to capital budgeting techniques such as, internal rate of return, net present value etc.

 

Explain the following concepts in relation to capital budgeting techniques. 
Sensitivity analysis
Scenario analysis
Break-even analysis
Simulation techniques.

This report has been prepared to identify the capital budgeting and the corporate decision making process in an organization. Investment appraisal technique i.e. capital budgeting is a process where various investments are analyzed on the basis of many variables to find out the best investment opportunity for an organization. Basically, long term investment opportunities are evaluated into capital budgeting techniques. These techniques are helpful for the company to manage the various factors and it looks over the various factors such as the PV factor, return, cash outflow, cash inflow etc. It has been observed that the long term investment could be various investment proposals such as diversification of market, buy new machineries, new plants, replacement of new machineries, various research development projects, new products and services into the market etc. it has been found that for conducting various tools to analyze the best investment proposal, an organization can take the help of sensitivity analysis, scenario analysis, break even analysis, simulation technique analysis (Damodaran, 2011).

Every organization wants to invest in a project which offers them maximum return in less investment as well as the associated risk is also lower in that case. For a better project, companies are required to look over the investment and then choose a best tool accordingly. Such as if company wants to earn a specific amount after a period of time, than company must go for scenario analysis as well as if the company wants to reach over a point where the cost is equal to the revenue than company must choose the breakeven analysis as a technique to opt the best available project (Barlow, 2006). This report will brief the user about the sensitivity analysis, scenario analysis, break even analysis, simulation technique analysis and their process and the situation where all of these tools could be used by the company to analyze the best result.

Sensitivity analysis:

Firstly, sensitivity analysis has been studied as a tool of capital budgeting technique to make a better corporate decision for the goodness of the company. Sensitivity analysis is an instrument which is used by companies to estimate that how several expanded values of an independent variable could be affected by a detailed variable that has been calculated through many assumptions by the managers. “What if” analysis is the other name of this technique. Normally, entire quantitative aspect of an investment proposal such as cash inflow, cost of capital, cash outflow, project duration, discount rate etc are predictable with an assurance. But in fact, these things rarely take place (Lumby & Jones, 2007). This analysis assists the companies to defeat the same difficulty of assumptions. The sensitivity analysis techniques could be useful over diverse planning actions and not only upon the capital budgeting corporate decision.

Sensitivity analysis assists an association into making the calculations that how the allocation of probable IRR and NPV for an investment proposal under few circumstance is impacted subsequently in a company to make an alteration into a sole variable which is reliant in scenery. This sensitivity analysis could occur only be altering into single variable at a time period. Sensitivity analysis calculates a rate for every variable and proposes a decision making procedure to the corporation to decide the best investment project (Moles, Parrino & Kidwekk, 2011). For instance, if the selling price of a product would be deducted by 20% and consequently, the IRR would also be distorted due to some changes in the life of the project to 5 years from 3 years. Thus this analysis assists the company to take superior decision about proposal of investment.

According to the above instance, every aspect would be altered due to various changes into a particular variable of the proposal. For instance, the changes which have been happened into the selling price would change the Net present value of the investment project and the project’s total life would make a collision over the IRR. Then the estimated NPV has been drafted into a graph to express about the sensitivity of the NPV which could take place due to various changes in the aspects (Tsanakas & Millossovich, 2016). The below graph express that the slope of NPV in the below chart express about the sensitivity of net present value which is occurred due to make some variations into every input. The sharp the slope will be, the more the sensitivity of net present value will be to create modifications into the variable.  

Companies widely use this technique because this technique is quite simple and this focuses over many related estimates. Mainly this technique is helpful for the companies to make decision related to the finance aspects.

Scenario analysis:

Scenario analysis has been studied as a tool of capital budgeting technique to make a better corporate decision for the goodness of the company. Sensitivity analysis is widely used as a technique of risk analysis but this study had some limits. Conversely, sensitivity analysis is supreme to contact with a variety of probability distributions of numerous inputs. Additionally, scenario analysis also helps the company to combine more variables so that the united effect might be investigated too with the alteration in more than 1 variable (Bierman and Smidt, 2012).

The scenario analysis provides a detailed answer of particular issues. Mainly, scenario analysis answers the problem that how terrible could an investment project look. Multiple times, companies just make an assumption about the factors and then they forget to take other assumptions according to the previous assumption and the rival’s relation and environmental and economy consideration etc. In this analysis; various factors are measured according to this scenario analysis which could be made by the companies. These factors could array from economical state to the rivalry’s response over any action of the company. Further, the components calculate the number for every factor in scenario analysis. Essentially, best, average and worst, these three scenarios are considered in the scenario analysis to make a best decision about the investment proposal (Garrison et al, 2010). Though, it has been observed that the long range could be varied. The next component of this analysis is to make a focus over various critical aspects and make a scenario for each factor. And at the end, each scenario’s probabilities are calculated. This scenario might be based upon various macro factors like exchange rate, interest rate and numerous micro factors like reaction of competitor.

Through the above table, it has been found that the above three scenarios are presented there for each investment project in the company. Through this scenario analysis, it has been observed that the 3 scenarios are obtainable in the company that are average, best and worst. Through this technique, it becomes quite easy for the companies to choose the better investment project.

Break even analysis:

Breakeven analysis assists an association into choosing the best proposal according to the associated cost and revenue association. In this technique, numerous tools of a project of investment are evaluated and then the breakeven level is investigated. An investment project’s breakeven level is a point where the revenue earned by the firm is equal to the total associated cost. In this analysis, a chart is plotted and in that chart, the cost slope and the total revenue slope are drawn (Grant, 2016). The interaction point is the breakeven point where both the slopes cut too each other. Break even analysis creates an idea regarding the optimistic return from a proposal of investment. This breakeven analysis express that a project’s fixed cost is not directly connected with the production level of the project and hence the breakeven level get affected through the project’s fixed cost. In addition, it has been found that a project’s variable cost directly make an alteration into the total volume of output.

Breakeven analysis study is an immense tool to recognize the association between the variable cost, returns and the fixed cost. Breakeven point provides an idea about the positive return from an investment proposal and it also express the worth of chart and mathematical calculation for this study (Shim, Siegel and Shim, 2011). This analysis assists an organization in estimating the level of manufacture through that the positive returns might be received by the firm. And the whole cost could be calculated properly.

The above breakeven point chart depict that the total 20 units are needed by the company to be manufactured to cover entire cost. Additionally, this much of manufacturing would assist the firm to make more profits. These estimations are helpful for the company to recognize the best obtainable project in the marketplace. And this study also assists the corporation to decide the return which may be received by the corporation after investing into a particular project. Additionally, it has been found that how much price would be rewarded by the corporation even in the concern of no production. Further, how many units are needed by the firm to produce units to reach over the breakeven point where the revenues and cost are equivalent.

Simulation techniques:

This study is also recognized as Monte Carlo simulation technique. It binds sensitivity and probability distribution jointly. This method of simulations is based upon different mathematical computations. The main essential request of this method is to offer judgment makers assistance along with the net present value’s probability distribution rather than a single judgment about the approximate NPV. This technique binds all the associated factors and then takes a decision about the numerous investment opportunities.  

In this analysis, firstly, a simulation implement process takes place to examine over the proposal and then various associated key factors which are concerned to approximate the exaggerated project and the inter relationship of that project with various other factors (Gervais, Heaton and Odean, 2011). This technique engages into modelling of cash outflow and inflow to divulge entire key aspects which are predisposed by cash payments as well as receipts and their association with other aspects.

Simulation technique engages the association of NPV with different limits and exogenous variables. This technique specifies the probability distribution and limit value of exogenous variables. Additionally, a value is chose erratically from probability distribution over every exogenous value (Burns and Walker, 2015). Adding up, NPV is calculated by corresponding over random generated value of pre specified variables and variables of parameters. More, the 3^rd and 4^th procedures are repeated over again to get a huge number of simulated NPV.  Lastly, in the graph, probability distribution slope is plotted and standard deviation and mean of returns are calculated to assemble the risk level.

This technique is analyzed to decide the top investment project from various available projects. Mainly, this analysis depicts its unease about the sensitivity analysis and probability distribution. This study assists the company to identify and assess the best available proposal from the available projects (Bodie, 2013). This analysis helps the company to assess the best plan for the company in context of the profits.  Simulation technique is a technique which is mostly uses by the organization to make a better decision about various investments which are the total time period in which company would be capable to repeal the entire cost.

Conclusion:

Through the above study, corporate decision making process in capital budgeting has been analyzed and it has been analyzed that the procedure is used by the company to calculate the numerous available opportunities to identify the best project from market. The technique of capital budgeting identifies the numerous projects according to their present value factors, cash flows, internal rate of return, accounting rate of return etc. for this study, it has been found that for conducting various tools to analyze the best investment proposal, an organization can take the help of sensitivity analysis, scenario analysis, break even analysis, simulation technique analysis.

Sensitivity analysis is an instrument which is used by companies to estimate that how several expanded values of a independent variable which would affect by a detailed variable that has been calculated through many assumptions by the managers. Scenario analysis answers the problem that how terrible could an investment project look. Multiple times, companies just make an assumption about the factors and then they forget to take other assumptions according to the previous assumption and the rival’s relation and environmental and economy consideration etc. Breakeven analysis assists an association into choosing the best proposal according to the associated cost and revenue association. In this technique, numerous tools of a project of investment are evaluated and then the breakeven level is investigated. And the main essential request of simulation method is to offer judgment makers assistance along with the net present value’s probability distribution rather than a single judgment about the approximate NPV. This technique binds all the associated factors and then takes a decision about the numerous investment opportunities.  

Thus through this study, it has been recognized that every risk analysis technique is best at their own way and helps the organization into various different situations.

References:

Barlow.J.F.,2006, Excel models for business and operations management, 2nd edition, John Wiley & sons ltd, England

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge

Bodie, Z., 2013. Investments. McGraw-Hill.

Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.

Damodaran, A, 2011, Applied corporate finance,3rd edition, John Wiley & sons, USA

Garrison, R.H., Noreen, E.W., Brewer, P.C. and McGowan, A., 2010. Managerial accounting. Issues in Accounting Education, 25(4), pp.792-793.

Gervais, S., Heaton, J.B. and Odean, T., 2011. Overconfidence, compensation contracts, and capital budgeting. The Journal of Finance, 66(5), pp.1735-1777.

Grant, R.M., 2016. Contemporary Strategy Analysis Text Only. John Wiley & Sons.

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Shim, J.K., Siegel, J.G. and Shim, A.I., 2011. Budgeting basics and beyond (Vol. 574). John Wiley & Sons.

Tsanakas, A. & Millossovich, P. 2016, "Sensitivity Analysis Using Risk Measures", Risk Analysis, vol. 36, no. 1, pp. 30-48.

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