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Approach of investing in assets for business

Question:

Discuss About The Budgeting Techniques And A Business Enterprise?

Under the different tools and techniques of capital budgeting, the management of the company considers the various capital outlays that it has under its proposals. The main exercise that is involved in the overall process of capital budgeting is to correlate the various benefits that are to be achieved over the period of time and consistency of performance that helps in maximizing the overall objective of the business. Management has to analyze risk as a key function of financial management. As it is generally seen that the long term investment decisions tend to be complicated in nature, there exist a high vulnerability of external risk and uncertainty. As the acquisition of business Assets and resources are the activities which are continuous and nature, therefore management should utilise their expertise in order to evaluate correct and fair valuation of business enterprise. In the current assignment, the analyst discussed over different concepts that are in relation to utilisation of capital budgeting techniques and a business enterprise. Some of them are discussed as follows -

Approach of investing in assets related to business are the major reasons for growth and development of the business enterprise. The company with the objective of achieving long term goals with timely approach must take efficient decision on the part of capital investments. Growth and development of the business organization are not only achieved through the purchase of new machinery and equipment but also expanding business operations through developing new products and services. Before investing and placing money into a project it is greatly required to understand and evaluate the associated risk, business strengths and weaknesses (??????? & ?????, 2011). Though risk cannot be completely avoided, but it should be minimised to acceptable business appetite. For this purpose management of the business, the organization must conduct sensitivity analysis as a part of capital budgeting technique in order to evaluate the possible risk and effectiveness of investment opportunities (Bennouna, et. al., 2010).

Sensitivity analysis as a part of capital budgeting techniques supports the business managers to evaluate the uncertain situations. As in a General scenario business activities are based on forecasts which are determined on the basis of certain assumptions and estimates. The technique of sensitivity analysis focuses on the part wherein the impact on the financial part of the company is visualised while making changes in assumptions and business estimates. The tool of sensitivity analysis evaluates the possible risk while determining the various variables that place an effect on the performance of the investment and associated net benefits. Various effects on changes made in the variable while conducting internal rate of return technique and net present value technique are analyzed and reported as a part of sensitivity analysis. The analyst using this report identifies various possible risk event and their resulted outcome and consequences if the above risk materialized (Correia & Cramer, 2008).

Sensitivity analysis as a part of capital budgeting techniques

Using this approach overall project feasibility is determined. Using net present value technique as a part of capital budgeting approach various independent variables are needed to be changed in order to determine the possible risk. Some of these variables are -

  • Expected revenue
  • Budgeted selling price
  • Budgeted cost of the investment
  • Initial cost of the project
  • Rate of return
  • Interest to be paid on loan etc

For instance, sensitivity analysis taken as part of capital budgeting techniques and calculation, it changes one part of the estimates that have been forecasted on the initial stage and accordingly the changes in results are to be evaluated. For example, in the case while taking projected cash flow for the next 10 years to determine the net present value of the investment the business organization took 8 % projected cost of capital. In this situation analysis, the analyst has three variables which can be changed accordingly to notice the effective change in the net present value of the project (Carmichael & Balatbat, 2008). There can be a variation witnessed over the period of time in the variables of time duration, the rate of cost of capital, and projected inflows.

Scenario Analysis is an analysis of Net Present Value (NPV) or Internal Rate of Return (IRR) of a forecast under various important scenarios, based on industry, firm economic factors, and macro-economic factors. It is a process of considering various future uncertain events by considering their alternative predictable outcomes. When future projection is made scenario analysis is considered to be a main factor. Then the various observations have been made regarding the future outcome and several developments have made to change the predictable outcomes. Scenario analysis is not based on the past data or historical data of the company. In scenario analysis the analyst expects that the past observations not remain same in the foreseeable future (Dedi & Orsag, 2007). Every scenario combines optimistic, predictable situations which affects the working of the company in the near future.

Scenario Analysis is plotted to permit improved decision making and planning by considering the various possible outcomes. In financial sector, financial institution might use scenario analysis to predict various possible situations for the economy (e.g. aggressive growth, moderate growth, conservative growth) and for the market returns (for stocks, bonds, cash and cash equivalents) in all of the scenarios. Financial institutions also made scenario analysis to predict the return on investments. Scenario planning starts by dividing the knowledge into two broad areas: 1 component we consider uncertain or unknowable and 2 things we believe we know anything about (Khamees, et. al., 2010).  It is the process of estimating the predictable value of the portfolio after a stipulated period of time, assuming that the securities in the portfolio has changed or key factors change such as change in the rate of interest on securities.

Scenario Analysis

There are many perspective of scenario analysis. A most and common method is to determine the risk of the portfolio by computing the standard deviation of monthly or daily returns of the portfolio. A consumer or group of person can use scenario analysis to examine the various financial possibilities of purchasing a product. Mathematics and Statistics plays an important role in the scenario analysis. Most managers use scenario analysis in their company is for framing a plan or in a decision making process to determine the best situation for maximizing the profits of the business and they also use this analysis to determine the worst possible outcome and anticipate operational losses and effective problems (Adair, 2011). This analysis also used in determining the net present value of the business in the near future.

Break even analysis is that analysis which determine the point at which sales of the company equals the cost associated with receiving the revenue. In alternate way we can say that break-even is that point where profit of the company is zero. Entities used Break even analysis to determine the level of units which company has to sell in order to cover their total fixed costs. Break even analysis concept deals with the contribution margin of the product. The contribution is the difference between the sales and the total variable costs. And the contribution margin is the difference of selling price and total variable cost per unit (Verma, et. al., 2009). Break even analysis plays a vital role in determining the practical application of cost related functions. It consist three factors, i.e sales volume, cost and profit. The aim of this analysis is to classify the between sales volume and total costs of the company. It is also known as cost-volume-profit-analysis. It helps in understanding the operating condition that exists when an entity ‘break-even’. This is also known as no profit no loss point.

This analysis has very useful to the company and the executives of the company takes forecasting decisions and make future planning by considering the break-even of the company. In break-even analysis a break even chart has made by the managerial economists, company executives and government agencies in order to find the break-even point. In the break even chart total fixed cost, total revenue and total variable cost are shown separately (Bierman Jr & Smidt, 2012). This break even chart shows the level of profit or loss to the entity at various levels of activity.

Break Even Analysis

In the situation of term loans, the institutions which have a business of finance have to find out the possibility that the person who took the loan can repay the loan. In such case they had to find the level of break-even point not only the total cost of the company are required but also the full debt of the person. That level of break-even is called cash break-even. A firm has to decide the most economical course of production both at planning level and expansion level. The break-even analysis is the most helpful in determining the best course of action. For management, the best use of break-even analysis is that they present a microscopic picture of the profit of the company and it helps in determining the business model of the company. Despite some limitations break even analysis has its own utility in managerial decision making. Considering the above technique as a part of the management tool for the purpose of taking short term decision it is considered highly worthwhile. Utilising this approach into current business condition works out as an additional advantage for a business manager to incorporate the fluctuations and changes that exist in the external micro environment due to its flexible behaviour (James, et. al., 2010).

Simulation technique as a part of capital budgeting methodology provides a natural and logical model in which various situations are analysed and a model is created for better decision making process. Various conditions in the real life business structure are analysed in order to formulate the better structuring of the future possible conditions. All aspects related to business are taken into study to make the sample structure on a wider part. Various variables forming part of the problems is identified that places an overall effect over the implementation part. The probable uncertain behaviour and outcomes in form of cash outflows are analysed as part of simulation techniques. Utilising the approach of Weingartner's Basic Horizon model as part of capital budgeting technique expected return on the investment is to be computed. The management utilising the simulation technique for its investment appraisal proposals is supported while evaluating the portfolio and generating the same for the organisation (Kwak & Ingall, 2007). The business can follow up the technique as presented by the Monte Carlo simulation approach in order to identify the probable risk and uncertainty that exist while determining the accuracy in the projected discounted cash flows associated with the project.

Simulation technique

The current approach of simulation reduces the shortcomings and lacking that does exist in the approach of scenario and sensitivity analysis. In spite of focusing on the impact on the performance due the change in the variable the analyst in the current approach takes random variable for each input and determines Net present value for each probable condition.

The above picture showcases the changes in assumptions in this particular approach of simulation, the management is required to justify and evaluate the probability for each available variable in order to determine the estimates (Hall & Millard, 2010).

Conclusion

The above assignment is related to risk and uncertainty that exist while making a capital appraisal decision. The particular capital budgeting decisions in the business sense are very important and relevant for considering the economic health of the business enterprise. The major objective while approaching for these techniques in the current consideration is to overcome the situation of risk and determine the different outcomes that may arise due to change in predicted variables. It requires a continuous monitoring and evaluation of various factors that are part of investment appraisal techniques and making a cost benefit analysis in order to determine the appropriateness of capital project.

References

Adair, T., 2011. Corporate Finance Demystified 2/E. McGraw Hill Professional.

Bennouna, K., Meredith, G.G. and Marchant, T., 2010. Improved capital budgeting decision making: evidence from Canada. Management decision, 48(2), pp.225-247.

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

Carmichael, D.G. and Balatbat, M.C., 2008. Probabilistic DCF analysis and capital budgeting and investment—a survey. The Engineering Economist, 53(1), pp.84-102.

Correia, C. and Cramer, P., 2008. An analysis of cost of capital, capital structure and capital budgeting practices: a survey of South African listed companies. Meditari accountancy research, 16(2), pp.31-52.

Dedi, L. and Orsag, S., 2007. Capital budgeting practices: a survey of Croatian firms. South East European Journal of Economics and Business, 2(1), pp.59-67.

Hall, J. and Millard, S., 2010. Capital budgeting practices used by selected listed South African firms. South African Journal of Economic and Management Sciences, 13(1), pp.85-97.

James, L.K., Swinton, S.M. and Thelen, K.D., 2010. Profitability analysis of cellulosic energy crops compared with corn. Agronomy Journal, 102(2), pp.675-687.

Khamees, B.A., Al-Fayoumi, N. and Al-Thuneibat, A.A., 2010. Capital budgeting practices in the Jordanian industrial corporations. International journal of commerce and management, 20(1), pp.49-63.

Kwak, Y.H. and Ingall, L., 2007. Exploring Monte Carlo simulation applications for project management. Risk Management, 9(1), pp.44-57.

Verma, S., Gupta, S. and Batra, R., 2009. A survey of capital budgeting practices in corporate India. Vision, 13(3), pp.1-17.

???????, ?.?. and ?????, ?.?., 2011. Sensitivity Analysis in Capital Budgeting.

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