Introduction to capital budgeting process

Question:

Discuss About The Company To Incur A Huge Amount Of Loss?

The process of capital budgeting is one of the most important processes that are used by the management of the company. This process is used for budgeting of the financial assets. The financial process is used for the determination of the different projects that include a capital outlay for the company. This includes the building of a building or a piece of equipment or buying it. There are the assets that any company invests in and hence, are of an utmost importance for the company (the balance, 2017).

Also, then there are independent and mutually exclusive capital investment projects in which the company makes an investment in. these are the projects that are of an utmost importance and the decision with regard to this is made by the business owner since it includes an increased amount of money. If this decision is not taken wisely, then that could lead the company to incur a huge amount of loss. There are many factors that have to be considered when making a capital investment decision. The rate of return on each one of the project has to be compared and the same would be kept in as against the weighted average cost of capital of the company which is as such not as simple as it sounds. The management of the company has to go through a number of different financial analysis so as to derive at the correct analysis. Also, the business would always want to estimate in the cash flows that would generated for the company due to the project. The hardest part of the cash flow is the estimates which tries in to determine in the rate of return of the project. There are many of the cash flow forecasting techniques that would help the company in choosing the projects (Radiomariamiami, 2017).

The process of capital budgeting is the method through which the investments that are of a longer duration are assessed and the various investments on the purchase or the replacement of the property, plant and equipment along with new line of the product and the other projects would be assessed. The techniques through which capital budgeting could be done include the following:

1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index

All of these above stated techniques are based upon the comparison of the cash inflows and the cash outflows that are related with each one of the project but follows different approaches when being applied.

Techniques for comparing cash inflows and outflows

• Payback period which helps in the measurement of the time which the initial flow of the cash is returned in by the project. These cash flows are not discounted and a lower payback period is always preferred.
• Net present value which equals to the difference between the net cash outflow and the net cash inflow. The project with the higher net present value and the investment is selected only if the net present value is positive.
• The accounting rate of return of the project is the profitability of the project which is discounted using the projected total amount of the net income which is divided by the initial or the average investment. The net income derived from each project is not discounted.
• Internal rate of return is the arte of discount in which the net present value of the project would become 0. The higher this return, the better it is for the company.
• Profitability index is the ratio of the present value of the future cash flows of the project kept as against the investment which is required in for each one of the projects (Accounting explained, 2017).

The above techniques are sued when the cash inflows that the company would receive over the time of the project are certain but what about the times and the projects when the cash inflows are not certain. Each and every project is connected with an uncertainty and hence, the risks that affects the way these decisions are made. The larger companies mainly uses different techniques such as the ones that have been explained below for the purposes of making the decision: (Colostate, 2017).

Break even analysis: this is one of the most useful techniques which points out the project as being loss making or profit making. The management has to make the decision as to the level of output that must be reached so that the company at least meets its costs. The following is an example of the calculation of break-even point. This is usually expressed in units but then it is also true that the company sometimes need to know the amount if the sales that must be realised for making those sales.

(CSUN, 2017).

The break-even analysis helps in studying in the relationship between fixed costs, variable costs and the return. It is the point at which a positive return is determined graphically. It helps in computing the volume at which the company would make no loss and no profit. The production below this level would lead to a loss for the company and the production higher then this level would lead to a profit for the company. Hence this is the minimum level of sales for the company (BEU, 2017).

This is the second technique which is used by the management in the process of decision making. This is the method of analysis which helps in the evaluation of the expected value of the proposed investment or the business activity. The statistical mean is the highest probability event which is expected in situations. By the way of creating these scenarios, one may be able to combine the same with probability that they would occur and an analyst would be able to determine in the value of the investment or the venture of the business and the probability which calculates in the expected value that actually occurs. This call for the determination of the probability distribution of the investment which is equal to the risk inherent in that stated investment. by the way of comparing in the expected return with the expected risk along with the overlaying of the risk tolerance of the investor, one would be able to make better decisions about whether to invest in the new project or not. The historical performance data is required in many of the cases which helps in gaining in depth knowledge about the variability of the performance in the investors and would also help in the investor in making the risks that is borne by the shareholders. The examination of the periodic return data would help in the assessment of risk in the past which is connected with the investment. In order to illustrate, wherein an investment which provides an equal return each year is expected to give equal and the same return each year, then that investment is termed as being less risky when compared with the return on the investment which gives out either a positive or a negative return which fluctuates. Though both of these investments would provide in the same return for any given investment horizon, the periodic return would help in the demonstration of the risk which differentiates in these investments. There are stricter regulations over the calculation and also in the presentation of the past returns which compares in the return on the information all across the securities. The past performance would not provide in the guarantee about the future risk or the return on the investment. This technique would help in understanding the potential risk and the return profile of the company. This is achieved by creating the probability distribution for any business enterprise. The examples of this technique include the performing of the multi factor analysis in the ways such as creation of a fixed number of scenarios such as determination of high or low spread ad creation of intermediate scenarios and performing the random factor analysis which includes many ways to infinite number of scenarios and Monte Carlo analysis (Udemy, 2017)

Estimating cash flows and forecasting techniques

Sensitivity analysis: whenever any project is being considered to be undertaken, then there are certain assumptions that needs to be made about the stated project. The number of units to be sold, the time that the project would take to complete, the cost of capital for the company. Hence, the management would need to undertake this technique so as to know the reliability of these assumptions and the way in which the project change that the company would go through in case wrong assumptions are undertaken. This is the way of measuring in the way in which the sensitivity outcome of the various assumptions about the project are taken. This changes the assumptions of the project assuming the other changes to be the same. This determines in the way in which the net present value and the internal rate of return undergoes a change. (Small business chron, 2017).

This technique of sensitivity analysis can be very useful for a variety of reasons, the first being the support of the decision making or the development of the recommendations for the decision makers. The example include testing of the robustness of the result. Another advantage of the same is the enhancement of the communication from the modellers to the decision makers. There is an increase in the understanding and the quantification of the system and also there is a development of a model such as searching for errors in the model.

Monte Carlo simulation: under this method, the statistical distribution of each one of the input is estimated. Inflation, risk etc in order to illustrate. Then these simulations are run in order to see the way in which the inputs undergo a change and the way in which it affects the output. This simulation is of an utmost importance since there are multiple of inputs involves that would go in for change and could also be unrelated. These simulations could be applied in to the different areas of business such as the bond pricing and are useful when it comes to the estimation of the base case which is quite difficult to be done by hand. For the purposes of accounting in of complex, interconnected factors that affects the financial outcomes, the companies must go in for the use of statistical methods. This is the method which solves in the issue which simulates in the underlying process and then helps in the calculation of the average result of the stated process (NTU, 2017). It helps in simulating the various sources associated with uncertainty. It also affects the value of the investment, portfolio, investment in question etc. this technique is designed for the purposes of finding out as to what happens to the outcome on an average when inputs undergo a change. Each one of the potential factor is assigned in a probability or statistic distribution. Suppose, an investor could estimate the return of 20% on a bond. This merely means that 20% of the time, he would not be able to earn back his principal. If he assumes the mean of 3% which is the inflation rate and 0.5% as the standard deviation, then he could assess and estimate the probability or the distribution of each one of the factors that would result in the change in the investment. This would mean running each distribution across many simulations of all of the inputs to ascertain the way in which the output would be affected and the average output would be found out. The main advantage of the stated method is the fact that this method would be able to handle in multiple moving and also possible related inputs. As the factors increase, it becomes harder for the company to figure out the base case (Lumen learning, 2017).

References:

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Udemy. (2017). Sensitivity & Scenario Analysis for CA / CFA / CPA Exams. [online] Available at: https://www.udemy.com/sensitivity-and-scenario-analysis-in-capital-budgeting/ [Accessed 15 Sep. 2017].

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