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Sensitivity Analysis

Discuss about the Project Report Corporate Financial Accounting.

Capital budgeting is a part of investment appraisal techniques. This planning process is used by the companies to evaluate the various investment long term opportunities. Capital budgeting process evaluates the various projects according their cash flows, present value factors, their net present value, internal rate of return, payback period, accounting rate of return etc (Zimmerman and Yahya-Zadeh, 2011). long term investment opportunities for a business could be new products, new plants, replacement of old machineries, new machinery, research development projects etc. for analyzing the best project, company takes the help of various tools which are available such as sensitivity analysis, scenario analysis, break even analysis, simulation technique analysis (Bierman and Smidt, 2012). It is required for every organization to evaluate the best investment proposal from the available proposals. And this could only be possible if the best corporate decision strategies have been adopted by the company.

Corporate decision making is a process which aids the organization into looking over various aspects and then makes a best decision for every dilemma of the business. Corporate decision making is a continuums process which takes place at every step in an organization. Corporate decision making sets a companionship among all the factors of the company and the stakeholders of the company (Gervais, Heaton and Odean, 2011). This report tells the user about various techniques and analysis which would aid the organization to select the best investment proposal according to the requirement of the company.   

Sensitivity analysis is a tool which is used by the various parties to evaluate that how many diversified values of a free variable would affect a specific variable which has been estimated through many assumptions. This analysis is also known as “what if” analysis. It has been observed that normally, every entire quantitative factor of an investment such as cash outflow, cash inflow, discount rate, cost of capital, project duration etc are recognized with certainty but in reality, it rarely takes place (Bierman and Smidt, 2012). Sensitivity analysis helps the companies to overcome the same problem. The techniques of sensitivity analysis could be applied over various planning activities and not only on capital budgeting decision.

This analysis helps an organization into evaluating that how the distribution of possible internal rate of return and net present value for a proposal under context is impacted consequently to make a change into a single variable which is dependent in nature. This analysis could take place only be changing into one variable at a time. Sensitivity analysis evaluates a value for every input and offers a decision making process to the company to choose the best project. Such as if a product’s selling price would be reduced by 10% and at the same time, the internal rate of return would also be changed due to changes into the total life of the project from 3 years to 5 years. Than sensitivity analysis, helps the organization to make a better decision about investment (Bennouna, Meredith and Marchant, 2010).

Scenario Analysis

As according to the above case, every factor will be changed due to change into a single variable of the investment proposal. Such as changes into the selling price will change the NPV of the project and the total life of the project will make an impact over the internal rate of return. Than the calculated NPV is plotted into a graph to depict that how sensitive the net present value could be due to changes into the related factors. The below figure depict that the slope of line in the below graph depicts that how sensitive the net present value is to make a change into each input. The steeper the slope would be, the more sensitive the net present value would be to make changes into the variable. 

(Hall and Millard, 2010)

Sensitivity analysis is used widely because of its ability and simplicity to focus over the specific estimates. Mainly it is used in the banking industry to evaluate the projects which are related to the funding. This analysis offers critical idea about the success or failure of the project.

It has been observed that the sensitivity analysis is used widely as a risk analysis technique but this analysis has some limits. Therefore, sensitivity analysis has been extended to deal with various probability distributions of various inputs and further, scenario analysis also aids the more variables at a single time so that the combined effect could also be analyzed with the changes in more than one variable (Adair, 2011).

Scenario analysis also offers a specific answer to this solution. Scenario analysis mainly answers the question of that how bad can a project look. Various times, mangers just take an assumption and forget to make other assumptions according to the competitor’s relation and economy consideration etc. in scenario analysis; factors are evaluated according to the scenario which has been built by the managers. These aspects could range from economy state to the competitor’s response on firm’s any action. Secondly, the components are determined the number of scenario analysis for every factor. Basically, three scenarios are determined according to the base, average and worst case. Though, it might vary according to the long range (Garrison, Noreen, Brewer and McGowan, 2010). The third component of scenario analysis is to focus over the critical aspects and build a scenario for every factor and lastly, in the forth component, probabilities of each scenario are evaluated. This scenario could be based upon many macro factors such as interest rate, exchange rate and various micro factors such as reaction of competitor.

Factors

Normal case

Best case

Worst case

Yield

-

+ 20%

-          30%

Exchange rate

-

+ 5%

-          5%

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

Break Even Analysis

(Burns and Walker, 2015).

The above tale depict that the three scenarios are there for every investment proposal in front of the company, through this analysis, it has been found that the three scenarios are available in front of the company which are best, normal, worst. Through this scenario, it becomes easy for the managers to choose the best investment proposal.

Break even analysis helps an organization into selecting the best project according to the cost and revenue relationship. In this project, various tools of an investment proposal are determined and then the level of breakeven is analysed. The breakeven level of an investment project is the point where the total associated cost is equal to the total revenue earned by the company. This analysis a graph is plotted and the total revenue slope and the cost slope are drawn. The point where both the slopes are interacted with each other is the point of breakeven (Shim, Siegel and Shim, 2011). Break even analysis generates an idea about the positive return from an investment. This analysis depict that the fixed cost of a project s not directly linked with the production level and thus the breakeven level get impacted through the fixed cost of the project. In addition, variable cost of a project directly makes a change into the volume of output.

The study of breakeven analysis is a great tool to identify the relationship between the returns, variable cost and fixed cost. Breakeven point offers an idea that when an investment proposal would generate positive return as well as it could be determined according to some mathematical calculations and graph (Grant, 2016). This analysis helps an organization to calculate the level of production through which the positive returns could be earned by the company. And the entire cost could be concerned properly.(Bodie, 2013)

The above graph of breakeven point depict that the total 9 units are required to be produce by the company to cover all the cost. Further, production would help the company to make profits. These calculations help the company to identify the best available project in the market. And this analysis also help the company to determine the total return which could be get by the company after investing into the particular project. Further, it has also been analyzed that how much cost would be paid by the company even in the case of no production and how much units are required by the company to produce to reach over a point where the cost and the revenue are equal (Fortson, 2011).

This analysis is also known as Monte Carlo simulation. It ties sensitivity as well as probability distribution together. This method is based upon various mathematical calculations. The main fundamental appeal of this technique is to offer decision makers along with a probability distribution of net present value’s rather than an only single estimation about the estimated net present value. This technique ties all the related factors and then makes a corporate decision about the various investment opportunities for an organization. 

Firstly, in this analysis, a simulation exercise takes place to investigate over the investment proposal and than many related key factors are involved to estimate the affected project and their inter relationship with other factors. This technique involves modelling of cash flows to disclose entire key factors which are influenced by both the cash payments and receipts and their relationship with other factors.

Simulation technique involves the relationship of net present value with various parameters and exogenous variables. It specifies the parameters value and probability distribution of exogenous factors and variables. Further, a value is selected randomly from probability distribution of every exogenous variable. In addition, NPV is determined corresponding to the random generated value of variables and pre specified variables of parameters. The 3rd and 4th steps are repeated again to get a large number of simulated net present values (Wright et al, 2010).  Lastly, the probability distribution is plotted and mean and standard deviation of return are computed to collect the risk level of a project.

Simulation techniques are analyzed to determine the best investment project form the various available projects in the market. This analysis mainly shows its concern about the probability distribution and the sensitivity analysis. This study helps the organization to identify and evaluate the best available investment proposal from the available projects into the company (Godfray et al, 2010). This analysis aids the company to evaluate the best business plan for the company in concern of the profits.  This analysis technique is a tool which is mainly uses by the association to make a superior decision about diverse investments i.e. the total time in which corporation would be proficient to reverse the entire connected cost.

Conclusion:

In the above study, capital budgeting technique has been investigated and it has been found that this planning process is used by the companies to evaluate the various investment long term opportunities. Capital budgeting process evaluates the various projects according their cash flows, present value factors, their net present value, internal rate of return, payback period, accounting rate of return etc. for this study, various tools such as sensitivity analysis, scenario analysis, break even analysis, simulation technique analysis have been analyzed and it has been found that all the analysis are helpful for the company to identify the best project from the available projects.

Through this study, it has been found that all the projects are helpful for the company in diverse situation. Sensitivity analysis is a tool which is used by the various parties to evaluate that how many diversified values of a free variable would affect a specific variable which has been estimated through many assumptions. Scenario analysis mainly answers the question of that how bad can a project look. Various times, mangers just take an assumption and forget to make other assumptions according to the competitor’s relation and economy consideration etc. In addition, Break even analysis helps an organization into selecting the best project according to the cost and revenue relationship. In this project, various tools of an investment proposal are determined and then the level of breakeven is analysed. Lastly, a simulation exercise takes place to investigate over the investment proposal and than many related key factors are involved to estimate the affected project and their inter relationship with other factors. And these analyses help the company to determine the total return and risk which could be faced by the company after investing into the 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.

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. 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.258-259.

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