Discuss about the Corporate Financial Management for Sensitivity Analysis.
Sensitivity analysis can be defined as an analysis that helps in knowing how sensitive an output can be to a change in the input while keeping other input constant. When it comes to corporate finance, it is defined as an evaluation of how a particular variable of an input in a capital budgeting decision like the discount rate, growth rate, etc influences the net present value, IRR or any other input with the other variables as constant. Sensitivity analysis is helpful in the manner as it addresses the user of the model how dependent the value of output is on each input. It provides a general notion of how much room is present for each variable to go into an adverse mode. It helps in the evaluation of risk (Davies & Crawford, 2012).
It is useful for a business because it helps in estimating what will happen to a project if the estimation turns out to be unreliable in nature (Albrecht et. al, 2012). It involves altering the estimates in a form of calculation to witness the impact on the finance of a project. In this manner, it helps the manager of the business to take a proper stand if the business does not lead to an expected result. Hence, the project can be evaluated beforehand and hence, the decision for investment can be taken accurately.
When it comes to the calculation of capital budgeting, evaluation alters one estimate at a particular time to witness the change in outcome. For instance, a business my forecast to earn $1000, $1500 and $1500 in the initial three years of the project. If an initial investment of $4000 is made by the business then the expenses will be recouping in three years. Further, the performance of the project may be enhanced as compared to the expectation that leads to a generation of $2000 on an annual basis in the second and third year respectively. The break-even of the business will happen in two years.
If we consider a manager Mr. A who wants to know the influence of increment of the customers on sales. Considering the entire study, he derived at an understanding that the sales are a function of the volume of the transaction and the goods prices. The goods prices stand at $2000 per piece and in the past year, a total of 200 pieces were sold in the previous year. Hence, the entire revenue stands at $400000. The manager Mr. A judges the pattern of various customer sales and observed that an increment of 20% in the base of the customer will lead to enhancing the sales by 10%. This data will enable preparation of a financial equation and sensitivity analysis that are linked to the situation of what-if. As per the sales of the present year and an estimation of the projection in the base of the customer, Mr. A can derive at the sensitivity analysis of the scenario. Hence, from the above example, it is crystal clear that sales are strongly linked to the changes in the base of the customer (Brealey et. al, 2011).
It is a tool that enables to evaluate the uncertainty by considering the outcomes of alternative nature. It need not be ascertained as a mechanism that is predictive in nature rather should be used a tool of analysis. For possible outcomes, three different scenarios can be judged like the base case, the best case, and the worst case. The base case is the one that contains the highest probability. The best case is the one where it is ascertained that all things move in the right direction and the worst case is deemed as a case where all the assumption makes no sense and fails miserably (Brigham & Daves, 2012). Therefore, the analyst needs to take steps so that the present risks should be covered that might lead to negative conditions. However, the specific situation is not known rather a notion is developed.
When it comes to a normal course of time, there is less surety is regarding the variables and the estimates in the case of capital budgeting. This is done to eliminate the uncertainty so that decision-making can be smooth and sensitivity analysis can be stretched to scenario analysis. It is the situation that determines the assumption and the change that is needed. One method of scenario analysis used in capital budgeting is utilizing the end in the case of extreme situations. As put to discussion in the above study that the best and the worst case situation are contrasted with the base case so that preventive measures can be taken into consideration leading to positive scenario (Ferris et. al, 2010). If the case turns out to be adverse than the scenario analysis will support the investors to be away from the situation that leads to adverse happening.
As per the discussion, it can be commented that both the method that is the scenario, as well as sensitivity analysis, are useful in knowing the best investment plan. However, there is a strong difference between the two. It needs to be noted that a scenario analysis might take the help of sensitivity analysis but it is not compulsory that the sensitivity will require the use of scenario analysis (Brigham & Ehrhardt, 2011). Moreover, the sensitivity analysis will enable the investor to understand various difficulties that are linked to the investment project that is proposed in nature. However, the scenario analysis will help in the evaluation of the various situation and the manner in which the impact in done on the result of the project.
Capital Asset pricing model
The capital asset pricing model can be said to be a model that helps in knowing about the fair value of an investment. CAPM computes the risk of the asset by evaluating the risk premium for every unit across the overall assets and evaluating the means of market beta. Hence, the CAPM module has a linear link between the market beta and the assets risk premium that can be considered as a risk that is methodical in nature. CAPM even illustrates that the return of an asset is affected due to the beta of the asset (Deegan, 2011). This model is based on the idea that the expected return will satisfy the investors for the return that is expected. Hence, the major consideration is the compensation to the investors in two major ways that are the time value and the risk. The formula of the asset can be written as
Expected return (ef) = Risk free rate + Beta*(Risk premium)
In simple terms, CAPM provides a prediction that is commanding in scenario regarding the way to evaluate the risk and return relationship. It needs to be noted that the CAPM empirical evidence cannot be said to be a major influencer. The assumption plan of CAPM I not aloof from the bias of data snooping (Libby et. al, 2011).
Capital Market Line
There are two main methods to attain the CAPM that is the capital market line and the security market line. When it comes to CAPM, the pricing of the securities is done in a manner so that the risk that is expected can be compensated by the expected returns. The capital market line (CML) provides the return of an investor for the portfolio. There appears a linear movement between the risk and return on the portfolio that is efficient. The CML is used to achieve the return from the portfolio. CML provides a rate of return and the one derived from it fluctuate as per the return that is risk-free and the level of risk as ascertained by beta for a particular portfolio (Graham & Smart, 2012). It is done by drawing a line of a tangent from the efficient frontier point to the stage where the risk-free rate and return that is expected tends to be equal in the scenario.
CML and CAPM Similarity
One of the main methods to achieve the CAPM is the CML and the SML. Hence, it is clear that CML is derived from CAPM. Hence, CML is unique in the sense that it helps in attaining the CAPM. Therefore, the features of the CAPM are embedded in CML. During the time of risk adjustment of an asset by utilizing the risk-free rate than the investor is at ease to alter the risk profile. When CML is considered, the market portfolio is comprised of the combined potent of the assets that are prone to risk and utilize the value of the asset market to predict the weights (Damodaran, 2012). The capital market line is generated from the CAPM and is used to drive at the exact rate of return that is needed. CML is powerful as compared to the efficient frontier and the risk-free asset that is present in the portfolio. The CAPM highlights the portfolio that is present in the market and is the efficient frontier. Hence, CML is an element of the CAPM and is a line that helps in projecting the return for efficient portfolio depending on the rate that is risk-free and the level of the risk. Hence, the features of the CAPM are involved in CML and therefore, features of CAPM are projected in CML.
Difference between CAPM and CML
There is hardly a big line of difference between the CAPM and CML. The CAPM is a method that that helps in the pricing of the securities so that the investor can understand the risk that is expected. CAPM is a holistic model while CML is a part of it that comes under the concept of CAPM. Therefore, CAPM can be stated as the best method to evaluate the return of an investor where the compensation will be made for the risk that is the systematic risk as diversification is not possible. However, the expectation from the investment can be done as per the involvement of the risk (Damodaran, 2010).
The CML takes into consideration the addition of asset that is risk-free and hence, it is classified better as compared to the efficient frontier. Each portfolio comprises of a Sharpe ratio in contrast to the market portfolio. When it comes to buying or investing, it is vital that the capital market line and Sharpe evaluated in tune with the portfolio (Bodie et. al, 2014).
Hence, as per the similarity and difference, it can be said that both the model are equally important in deciding the required rate of return for a portfolio. The similarities are more in nature and carry a very little line of difference (Bodie et. al, 2014). As per the report, it can be commented that both the method are equally important and used together that provides a better answer.
Going by the overall analysis it can be commented that taking financing decision is the need of the hour. It requires certain specific skills and effective tools. In this scenario, both the method sensitive and scenario analysis plays a predominant role in capital budgeting. The user can take an effective result and proceed with the investment. On the contrary, CAPM and CML help in deriving the expected return and used together. Both the concept focuses on the expected return and gives an emphasis to the risk prevalent in the market.
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