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Importance of Financial Tools in Investment Decisions

Discuss About The Journal Of Economic And Management Sciences?

Organization is accompanied with the complex set of activities in which various functions are performed with a view to achieve certain level of goals and objective. There are several financial tools such as ratio analysis, capital budgeting tools, NPV IRR, profitability analysis. These tools are used by investors or companies to evaluate the best suitable investment option which could be undertaken by organization to make effective use of resources in organization. It is observed that Net present value and IRR are the most suitable financial tools to select the most profitable project in the given options. It is evaluated that if companies could use these capital budgeting tools in effective manner then it will increase the overall investment value. (Zimmerman and Yahya-Zadeh, 2011).  Ideally, these capital budgeting tools are used by organization when long term investment decisions are made. For instance, when Company ABC wants to invest AUD $ 1, 00,000 in particular project. Company is having 5 project options to invest its capital. In this case, project giving higher NPV and IRR will be accepted by the organization. It is considered that Net present value not only reflects the higher cash outflow but also showcases the present value of the investment or present value of cash inflow and outflow of business which it will have in future. This level of financial tools could be useful to create best value on the invested capital (Bier man and Smidt, 2012).

It is evaluated that corporate decision are the key pillar for the success of organization. Investment in the particular project options may result to destruction of business if these are not taken in proper specific manner (Bennouna, et al. 2010).Financial tools such as ratio analysis, capital budgeting tools, NPV IRR, profitability analysis provide deep understanding on the associated financial factors of business. This will increase the overall project effectiveness and business and investment decisions (Gervais, Heaton and Odean, 2011). In this report, sensitivity analysis, scenario analysis and other capital budgeting tools have been depicted (African firms, 2013).

Sensitivity analysis is a tool which provides clear view points on the variable factors on the particular investment decisions while selecting project in organization. It provides diversified value of free variables which would affect a specific variable on the basis of various assumptions and factors. However, with the ramified changes in economic factors, this Sensitivity analysis is also known as what if analysis. This analysis provides idea about what would be the changes in the cash flow of business if particular variable factors are not stable. With the help of this analysis, company could identify the particular changing factors and evaluate the changes which would occur in the selected project (Godfray, et al. 2010). For instance, If Company ABC wants to invest AUD $ 1, 00,000 in particular project. Company is having 5 project options to invest its capital in market. After implementing IRR and NPR, it is evaluated that company is having AUD$ 1, 20,000 cash inflow after five years (Shim, Siegel and Shim, 2011).  With the help of Sensitivity analysis, investors could reconsider cost of capital based on the market inflation rate, purchasing power of economy and other associated economic factors. After sensitivity analysis, company could easily identify the changes in overall cost of capital and its impact on the inflow and outflow of business (Bierman and Smidt, 2012). Sensitivity analysis is used by the companies around the globe to identify the particular investment options and associated changing market factors that could influence company’s inflow and outflow (Wright, et al. 2010).

Sensitivity Analysis

With the help of this analysis, company could gauge the possible changes in its cash inflow and outflow of business if market factors and economic factors would change. Changes in market factors will mostly affect the cost of capital of organization. This cost of capital helps organization to determine the present value of the invested amount in business. This could be determined with the example that if particular project is having 5 years life and cost of capital 10%. If due to changes in inflation rate cost of capital is also changed to 12% then it will decrease the overall cash inflow of business and net present value of the business (Bennouna, Meredith and Marchant, 2010).

Therefore, it could be inferred that if market and economic factors are changed then it will also impact the investment proposal and selected project options. Net present value provides the difference between present value of cash inflow and present value of cash outflow in the business. It is considered that if there are changes in associated factors of business then it will change the amount of net present value at large (Zimmerman and Yahya-Zadeh, 2011).  After evaluating all the factors and calculations of projects, below graphs could be used to showcase the changes in net present value after implementing sensitivity analysis (Adair, 2011).

Sensitivity analysis is the main major tools which could be used to evaluate the associated risk and undertaking factors. This analysis is most useful when there is high fluctuation in the market (Fortson, 2011).

It is considered that sensitivity analysis is used to analysis the associated risk and marketing changing factors but due to its cumbersome process it has some limitations. Sensitivity analysis is used to evaluate the factors and affecting factors which could emerge due to the changes in more than one factors of market. This analysis helps investors to evaluate the possible changes in investment project and its associated factors which may result to changes in the cost of capital and cash inflow and outflow (Adair, 2011). Scenario analysis is implemented to identify the possibilities of project viabilities. It is considered that project is measured on the basis of present factors. On the other hand, Scenario analysis is implemented to evaluate all the possible changes and fluctuation in market and economic factors for the viability of project. In these Scenario analysis investors has to take assumption of three scenarios such as base, average and worst case (Garrison, Noreen, Brewer and McGowan, 2010). These all three case of the company is based on various factors such as exchange rate, yield, transportation, economic growth rate, purchasing power and employment rate of country (Garrison, et al. 2010).

Factors affecting project investment  

Normal case  

Best case

Worst case

Yield

-

+ 25%

-          24%

Exchange rate

-

+10%

-          8%

Transportation cost

-

-15%

+25%

Marketing cost

-

-8%

+23%

Sales cost

-

+ 5 %

-          15%

Sales price

1.03

1.05

1.00

Cash inflow

10 %

19 %

3%

NPV

1

2.5

-2.3

Scenario Analysis

(Burns and Walker, 2015).

These three scenario events best, normal, worse could be considered by organization to make investment decisions in determined approach.

Break even analysis is used by organization to determine the points at which company could sell its products and service at no profit no loss.  It is point at which company would have no profit no loss and sells its product at breakeven point. Ideally this break even analysis is used by company to create core competency in cost leadership in market (Shim, Siegel and Shim, 2011). These points provide idea to company to sell its products and services at which it could cover all its variable expenses. This analysis is used to eliminate the competition for the market by selling products at break even. Companies could find this point by implementing proper graphical view points and computing its fixed and variable expenses (Grant, 2016).

A ratio analysis, capital budgeting tools, NPV IRR, profitability analysis will helps investors to determine which project options will offer higher profit and value creation on their investment. Now in the end, it could be inferred that use of sensitivity analysis and scenarios analysis will increase the effectiveness of NPV, IRR and other capital budgeting tools while selecting particular 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.

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

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

Fortson, J.G., 2011. Mortality risk and human capital investment: The Impact of HIV/AIDS in Sub-Saharan Africa. The Review of Economics and Statistics, 93(1), pp.1-15.

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.

Godfray, H.C.J., Beddington, J.R., Crute, I.R., Haddad, L., Lawrence, D., Muir, J.F., Pretty, J., Robinson, S., Thomas, S.M. and Toulmin, C., 2010. Food security: the challenge of feeding 9 billion people. science, 327(5967), pp.812-818.

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

Hall, J. and Millard, S., 2010. Capital budgeting practices used by selected listed South African firms, 2013. South African Journal of Economic and Management Sciences, 13(1), pp.85-97.

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

Wright, M.M., Daugaard, D.E., Satrio, J.A. and Brown, R.C., 2010. Techno-economic analysis of biomass fast pyrolysis to transportation fuels. Fuel, 89, pp.S2-S10.

Zimmerman, J.L. and Yahya-Zadeh, M., 2011. Accounting for decision making and control. Issues in Accounting Education, 26(1), pp.258-25
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