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FIN200 Corporate Financial Management

tag 0 Download 0 Pages / 0 Words tag 16-06-2022
  • Course Code: FIN200
  • University: Kings Own Institute
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  • Country: Australia

Answer

Capital Budgeting Techniques

Introduction

Management decision making is the most complex process that involves project selection in order to accomplish the organization goals. Project selection means selecting the best option from the available choice of projects. Capital budgeting is the process that helps the managers to analyze the projects on the various grounds such as their profitability, risk and uncertainty. Capital budgeting decisions can be taken to accomplish the requirement of working capital and also to acquire the fixed assets. Other than project selection can also be done using the techniques provided in the capital budgeting. The process of capital budgeting is truly based on cost benefit analysis and cash flow generated by the project. So it can be said that there is no arbitrary method of selection under capital budgeting decisions. There are various methods available to analyze the projects but net present value (NPV) and internal rate of return (IRR) are widely used due to their precise decision making capacity (Otley and Emmanuel, 2013).

The net present value and internal rate of return can further be analyzed using the methods such as sensitivity analysis, scenario analysis, breakeven analysis and simulation analysis. The purpose of report is to check role that capital budgeting decisions play while performing the managerial process. So, NPV and IRR method will be analyzed in detail on the ground of all the four analysis techniques.

Net Present Value and Internal rate of return

In order to better understand the techniques of capital budgeting it is essential to understand the concept of NPV and IRR. Both these methods are impacted by all four techniques namely sensitivity analysis, scenario analysis, breakeven analysis and simulation analysis.

Net present value is based on the amount of initial investment made and amount of cash flows generated by the project in future. The future cash flows are discounted using the time value and converted into the present value to compare with initial investment. Investments are usually made at initial stage in form of fixed assets and at later stage in the form of working capital. Cash inflows are dependent upon the future expected incomes and expenses occurred to earn that income. It can be said that expected sales income depends on the sales volume and market size. It can be concluded from the above information that NPV is impacted with the change of variables like expected revenue, cost, sales volume and market size. These variables can be divided in micro and macro level i.e. variables that changes due to internal company policies and variables that change due to impact of external conditions. Cost of the project can include initial investment (mainly treated as depreciation over the life of project), variable cost and fixed cost that occur every year (Baker, 2011). The NPV and IRR methods usually use cash outflows and inflows, and cost of capital i.e. discount rate to analyze the projects. So the variables that change these values will also change the values during the analyses. In the sensitivity analysis there can be three main cases such as, pessimistic (Worst Case), expected case and Optimistic (Best Case). The analysis technique used to calculate the change in NPV and IRR under all three cases is called as sensitivity analysis (Otley and Emmanuel, 2013).

Net present Value: Net present value is calculated as present value of cash inflows less present values of cash outflows. Time value methods are used to calculate the present value of cash inflows and cash outflows. Net present value means the profit the project will provide at the present time if project is selected today. Positive value of NPV means that project will generate the income and negative NPV means the project will generate loss if chosen.

Formula to calculate the NPV is given as: Present values of cash inflows less present values cash outflows

Internal rate of return: IRR provides the rate of interest at which project will provide the returns to the company. It means if project is implemented, the company will earn income at the rate calculated by the IRR method. In this method it is very easy to make selection of projects. Selection of projects is done whose rate of return is highest and greater than the cost of capital. Cost of capital means discount rate on which company has to pay the interest on the capital taken (Weygandt, Kimmel and Kieso, 2009). In case the rate of return is lower than the cost of capital than the project will be rejected on the grounds that it will not provide any extra revenue to the organization.  Formula to calculate the IRR is given as:

Internal rate of return: R (A) + NPV (A)*[R (B)-R (A)] / [NPV (A)-NPV (B)]

R (A) = discount rate (lower)

R (B) = discount rate (higher)

NPV (A) = value calculated using NPV method under lower rate of discount

NPV (B) = value calculated using NPV method under higher rate of discount

Discussion of all the four analysis techniques that impacts the results under NPV and IRR

Sensitivity Analysis

As discussed before sensitivity analysis means techniques used to evaluate the project through using NPV and IRR under different conditions. Under this analysis technique the depended variables are changed and impact on the value of NPV or IRR is noted to check how much project is influenced to that change. So it can be said that this technique is used to check how the various values of independent variable react to the underline dependent variable within the given set of assumptions. With the help of this analysis technique management can decide how project will response under various situations. Every organization is prone to various circumstances that can be good, normal or worst depending upon the situation. So it is important to analyze the projects under every situation so that management will be aware of pro and cons of that particular project. Under sensitivity analysis dependent variables that are used to calculate NPV and IRR are changed and change in other value are noted to check how much the NPV and IRR are affected due to change in one dependent variable (Otley and Emmanuel, 2013). The sensitivity analysis has series of steps that have to be followed while carrying out the process:

  • In first step, all the dependent variables are identified that impact the value of NPV and IRR
  • In second step, relation between the different dependent or independent variables are framed in order to calculate the values of NPV and IRR under different situation.
  • In the last step, evaluation table is prepared to check the impact of change in value of NPV or IRR due to change in dependent variables

Now, to have the better understanding of the sensitivity analysis method it is important to understand this through use of example. In this example three situations have been taken as discussed above, pessimistic, expected and optimistic situation. It is decided to change the value of cash inflows, initial cash flows and fixed cost to check the change in all three situation (Baker, 2011).

When there will be change in values of cash inflows:

Possible outcomes of cash flows and other variables under different situations

Variables

Pessimistic

Expected

Optimistic

Initial Investment

 $              50,000.00

 $             50,000.00

 $       50,000.00

Cash Inflows (Sales) (PV)

 $           140,000.00

 $          160,000.00

 $    180,000.00

Expenditures or cash outflows (PV)

 $              60,000.00

 $             60,000.00

 $       60,000.00

Fixed cost (PV)

 $              20,000.00

 $             20,000.00

 $       20,000.00

PV = Present Value

 

 

 

NPV under different Situation

Changing the cash inflows

Pessimistic

Expected

Optimistic

Net Present Value

 $              10,000.00

 $             30,000.00

 $       50,000.00

When there will be change in values of fixed cost:

Possible outcomes of cash flows and other variables under different situations

Variables

Pessimistic

Expected

Optimistic

Initial Investment

 $              50,000.00

 $             50,000.00

 $       50,000.00

Cash Inflows (Sales) (PV)

 $           160,000.00

 $          160,000.00

 $    160,000.00

Expenditures or cash outflows (PV)

 $              60,000.00

 $             60,000.00

 $       60,000.00

Fixed cost (PV)

 $              30,000.00

 $             20,000.00

 $       10,000.00

NPV under different Situation

Changing the initial investment

Pessimistic

Expected

Optimistic

Net Present Value

 $              20,000.00

 $             30,000.00

 $       40,000.00

When there will be change in values of initial cost:

Possible outcomes of cash flows and other variables under different situations

Variables

Pessimistic

Expected

Optimistic

Initial Investment

 $              75,000.00

 $             50,000.00

 $       25,000.00

Cash Inflows (Sales) (PV)

 $           160,000.00

 $          160,000.00

 $    160,000.00

Expenditures or cash outflows (PV)

 $              60,000.00

 $             60,000.00

 $       60,000.00

Fixed cost (PV)

 $              20,000.00

 $             20,000.00

 $       20,000.00

NPV under different Situation

Changing the initial investment

Pessimistic

Expected

Optimistic

Net Present Value

 $                5,000.00

 $             30,000.00

 $       55,000.00

As seen above that even a small change in the dependent variable has changed the values of NPV. So it is concluded that NPV is prone to sensitivity analysis and it is very important to carry out the sensitivity analysis before selecting the project (Moyer, McGuigan and Rao, 2014).

Scenario analysis 

This method of analysis is almost similar to the sensitivity analysis but in this techniques multiple changes are made together to come with the particular situation. Under this analysis technique NPV and IRR are put to test under the various situations so that results can be noted in each and every scenario. The conditions of the organization are not always the same and it changes according to time or due to any mis-happening with the management. So it is essential to carry out the scenario analysis of the project so that management prepares them for every condition. Change in any dependent variable can be decided on the bases of probability of occurrence of any event. So under this analysis method various situations are created that are supposed to be occur and they are combined together through their probability of occurrence. Probability means percentage of most likely occurrence of the particular situation. Estimating the probability is truly based on the risk bearing capacity of the organization. So it can be said that estimating the values NPV and IRR under different situation with comparing it estimated risk and return is referred to as the scenario analysis. Scenario and sensitivity are almost same but scenario analysis is better estimation of the project as it combines probability of occurrence of different situation. Cost manager can estimate exact situation under the different types of scenario and makes the decisions accordingly (Smit, 2007).

Scenario analysis can be easily understood through the example:

Under his example a scenario is taken where company has make the investment of  $ 1,050,000.00 and all the variables are defined. The impact of competition with the same level of competitor is taken under this scenario analysis. Assumptions made are: Cost of capital: 8% and years of investment: 5 years.

Variables

Given Case

Impact due to Competitor

 

 

Sales

 $        1,200,000.00

 $           1,080,000.00

Variable Cost

 $            480,000.00

 $              486,000.00

Fixed cost

 $            150,000.00

 $              150,000.00

Depreciation

 $            200,000.00

 $              200,000.00

Pre-Tax Profit

 $            370,000.00

 $              244,000.00

Taxes @ 30%

 $            111,000.00

 $                 73,200.00

Profit after tax

 $            259,000.00

 $              170,800.00

Cash flow from investment

 $            459,000.00

 $              370,800.00

Present Value of CF (5years)

 $        1,832,787.00

 $           1,480,604.40

Investment Made

 $        1,050,000.00

 $           1,050,000.00

NPV

 $            782,787.00

 $              430,604.40

CVF @ 8%, 5 years

3.993

 

Simulation Analysis

This method of analysis considers various situations that are faced by the company under real life condition.  This method is truly based on the assumption based through use of probability together with the other conditions. The future is unpredictable due to changes made by the technology, government interference and other economical factors. This method used random numbers to create the various situations and this is performed many times and very time results are noted to come out at the best possible match. This method is called as Monte-Carlo Simulation (Otley and Emmanuel, 2013).

Break Even analysis

This method of analysis is very important to check the point where the project outcomes to be of zero return to the company. It means this analysis technique provides the point under the NPV or IRR method that will yield no loss and no gain to the company. As per the company point of view in order to survive in the competition it is essential to give competition in the market but it is also necessary to do not cross the breakeven point as it will give loss to the company. In breakeven analysis variable expenses can be recovered but it is not possible to recover the fixed charges. The point of NPV where its value is zero is regarded as point of breakeven (Otley and Emmanuel, 2013).

Conclusion

It can be concluded that capital budgeting techniques play an important role in management decisions making process. All the four analysis techniques are considered as important for valuing the project for the benefit of the company.

References

Baker, H.K. 2011. Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. John Wiley & Sons.

Moyer, C., McGuigan, J. and Rao, R. 2014. Contemporary Financial Management . Cengage Learning.

Otley, D. and Emmanuel, K. 2013. Readings in Accounting for Management Control. Springer.

Smit, P.J. 2007. Management Principles: A Contemporary Edition for Africa. Juta and Company Ltd.

Weygandt, J., Kimmel, P. and Kieso, D. 2009. Managerial Accounting: Tools for Business Decision Making. John Wiley & Sons.

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