Capital budgeting techniques

Discuss About The Capital Budgeting Techniques Outlook Italy?

Capital budgeting practice is considered to be one of the important inputs in investment process of making decision getting onto the investment projects management. A precise good analysis, evaluating, scrutiny, monitoring, and implementation of such investments or project could produce the expected outcomes for the shareholders.

According to Ghahremani, Aghaie, and Abedzadeh (2012), the capital budgeting practice aspects are used to make the decision for investment in order to increase the value of the shareholders. Capital budgeting is mainly concerned with substantial investment in long-term assets because these particular assets may be tangible like plants, properties, and equipment or can also be intangible like research and development, design, new technology, trademark and patent rights. This assignment attempts to explain how management could use sensitivity, scenario, breakeven and simulation techniques in relation to the aspect of capital budgeting.

This is a capital budgeting that refers to a length of time that it takes for an investor to recover back the initial amount invested in a project or a property (Ahmed, 2013). Since payback period is considered to be a traditional method of budgeting, managers usually employ this particular method when determining the length of time that an investment will pay back the capital invested.

This is the rate of interest at which the NPV of the cash flows that is either negative or positive from a project or venture equals to zero. Internal Rate of Return (IRR) is utilized to assess the project effectiveness because if the IRR of a new investment surpasses a firm needed rate of return, then the project is appropriate (Maroyi, and Poll, 2012). The company should reject any project that its Internal Rate of Return (IRR) falls below the rate of return that is required company. According to Internal Rate of Return (IRR) concept, management usually employs this particular method so as to determine the effectiveness of the project because basically, IRR should be in excess of the return rate that is required for an invested project.

The Net Present Value (NPV) is a financial accounting method that involves the discounting of all the cash flows and computing the present cash flows value at a given discounting rate usually called the cost of capital or the required rate of return. The initial cash outlay is then deducted present value so as to obtain the Net Present Value. (NPV = P.V – Io). In case the project has a salvage value, the present cost of the salvage value should be added to the cost of the present value of the given cash flow (Daunfeldt, and Hartwig, 2014). This technique is important for managers because it considered the time value of money and is basically consistent with the aims of maximizing revenues for the owners.

How all of those management decision making can be related to capital budgeting techniques

Profitability index is considered to be the proportion of the present cost of future cash flows of an investment to its initial project that is needed for the investment. This particular technique is usually used by the managers in determining the ratio of the future cash flow of a project at hand (Rossi, 2014). Basically, profitability index measures the present value of returns that is derived from per amount invested that will show the basic relationship between the cost and the benefits of the project.

Sensitivity Analysis is basically reffered to as the technique that is utilized to determine how different values of an independent variable might impact a specific dependent variable in a provided set of estimates (Ahmed, 2013). It is usually used in specific limits that will rely on more or one input variables like the impact that varies in rates of interest will contain on a price of a bond. Sensitivity Analysis helps in measuring the sensitivity of a decision to the changes in the variables of one or more parameters. This particular analysis is considered to be a way of examining changes in the projects Net Present Value for a provided variation in one of the variables. Sensitivity Analysis basically shows how profound the projects IRR or NPV are to the changes in a particular variable. The more sensitive is the Net Present Value, the more acute is the variable (Brunzell, Liljeblom, and Vaihekoski, 2013).

• Identify all the variables that have an impact on the investments NPV or IRR
• Define the fundamental correlation in the variables.
• Analyze the impact of the changes in each of the resultant variables on the investments Internal Rate of Return or Net Present Value.

The maker of the decision while executing the aspect of Sensitivity Analysis considers the investments Internal Rate of Return or Net Present Value for each projection in three assumptions; optimistic, expected or pessimistic (Cooper, Cornick, and Redmon, 2011). Basically, sensitivity analysis allows asking what if questions. For instance, what is the Internal Rate of Return or Net Present Value if the volume decreases or increases? What is the IRR or NPV if the price decreases or increases?

The technique has been proved to be static since it only analyzes one factor at a particular time that basically makes the managers rely on their personal judgment. Even though the technique is considered to be good, it may need managers to have more skills on how to carry out break-even analysis and correlation that may make it complex to be used in small and medium companies especially in the developing countries, and this hence makes the technique less applicable in less developed or developing nations (Rossi, 2014).

Steps encompassed in Sensitivity Analysis usage

Sensitivity Analysis helps an organization approximate what will occur to the projects if the estimates and assumptions turns out to be unpredictable since it often encompasses changing the estimates or the assumptions in a calculation in case the investments does not produce projected outcomes, so they can better analyze the venture before contemplating for investment. This aspect is useful to managers because they will have a clear perspective of a project before moving on to invest in the project.

While sensitivity analysis is considered to be the most commonly utilized tool for accessing the risk of the project, the managers are usually interested in knowing how the project will behave if diverse variables change at the same time. Basically, scenario analysis is considered to be a tool that overcomes the limitation of the sensitivity analysis. It often measures the change in Net Present Value of the project under different scenarios, changing diverse variables at a time because of the interrelationship of variables among themselves. Scenario Analysis is the technique of analyzing probable future activities by considering possible different results (Burns, and Walker, 2015).

Numerous scenarios are established in a scenario analysis to demonstrate probable future results, and it is basically used to produce a combination of an optimistic, pessimistic, and most probable scenarios. Scenario analysis commonly emphasizes on estimating the value of the portfolio that could decrease to, if an unfavorable activity of the worst case was realized. The first step in utilizing this particular technique is to determine the Internal Rate of Return or Net Present Value then identify all the possible errors of these particular cash flows and the investigate the major effect or impact of diverse assumptions on the Internal Rate of Return or Net Present Value. In reality, scenario analysis cannot be used to determine the project alone; it can also be utilized to supplement other evaluation techniques by identifying the factors that affect the cash flows of the project such that company managers or directors can consider them (Baker, and English, 2011).

Scenario Analysis offers a means to evaluate the potential variability in a capital budgeting projects Net Present Value for managers. By carrying out a scenario analysis, an investor can basically produce a risk profile for a forecasted investment and build a basis for comparing prospective projects or investments that can enhance production.

Break Even Analysis focuses on the determination of minimum volume per revenue that would result in recovery of all expenses. As long as revenue results, the profit variation is considered an issue by the management because the main aim of the management is not to make any loss. Under Break Even Analysis, managers can make an assessment that regards probability of not attaining the Break Even level of sales. The lower the Break Even or further the expected level of operation from the Break Even point, the safer the projected anticipated. This particular aspect is referred to as the margin of safety (Hasan, 2013). Though a simplistic perspective of risk, it basically serves the objective of risk assessment. Break Even Analysis requires a minimum amount of data as nor other input are needed besides those already prepared for evaluation of information.

Scenario Analysis

Each method has its own demerits and merits and the ability of the shareholders in the project. If a particular method is inferior or superior depends on the situation. For instance, it would be purely fruitless and impractical to run a simulation activity for a paltry investment. Similarly, financial institutions while offering financial assistance to a project, they depend heavily on sensitivity analysis because simulation or scenario analyses are too big for them. However several managers who have to take a number of critical decisions are considered to be more concerned with Scenario Analysis that the Sensitivity Analysis during capital budgeting. Break Even Analysis works like sensitivity analysis in capital budgeting because it basically analyses price, cost and sales volume and how they impact of the organization revenues or profits. The techniques are useful to managers during capital budgeting because it shows if the project Break Even in the accounting terms (Chai, 2011).

Break Even Analysis is also vital for managers when performing capital budgeting because it often facilitates the managers to have a clear perspective of the project or investment he or she plans to undertake in that projects or investments that break even early is considered to be viable investments that should be invested on.

Simulation Analysis technique is considered to be a technique that combines both the scenario and sensitivity analysis in analyzing risks in a particular risks project cash flows. It basically identifies the main factors that affect their interrelationship and the profits. These cash flows are embedded to demonstrate the main factors that influence the payment and the cash receipt and their interrelationships (Bierman and Smidt, 2012(. Even though according to the capital budgeting perspective, Simulation Analysis technique theoretically looks good but in practice, it may be complex and expensive to be utilized especially for small and medium business and also in the developing nations since it requires the use of computer software.

Simulation Analysis technique is also referred to as a computer-based exercise that generates a large number of situations and computes Net Present Value of each of them so as to find out the distribution of Net Present Value, its projected standard deviation and the value as a measure of risks. Simulation Analysis or Monte Carlo Simulation technique considers the interaction among variables and the probabilities of the change in the variables. It basically computes the probability distribution of the Net Present Value. Basically, the Simulation Analysis encompasses the following steps;

• Identification of exogenous variables that impact cash outflows and inflows of the project and its Net Present Value such as selling price, demand, size of the market and variable costs (Hise, and Strawser, 2013).
• Understanding the relationship between the Net Present Value and the variables such as profits depends on sales prices and volume, the volume of sales basically depends on the size of the market and market share.
• Specification of the probability distribution for each of the exogenous variable.
• Finally, developing a computer program that randomly selects one value from the probability distribution of each variable and utilizes this value so as to calculate the project’s NPV.

Simulation Analysis basically overcomes the limitations of scenario and sensitivity analysis by basically analyzing all the effects of all the possible combinations of the variables and their realization (Rossi, 2015). Even though there is no difference with the inputs like in scenario analysis, this technique treats the estimates as a triangular distribution with the possibility of worst case and best case working capital being close to zero and also increases linearly up to the most likely case.

Conclusion

Because, resources are often limited in its accessibility, capital investments are evaluated exclusively using both qualitative and quantitative data as most capital budgeting examination uses cash outflows and inflows instead of net income evaluated through the accrual basis. Capital budgeting techniques are vital tools that enhances the company management to determine the most viable investments to undertake that have high returns.

References

Ahmed, I.E., 2013. Factors determining the selection of capital budgeting techniques. Journal of Finance and Investment Analysis, 2(2), pp.77-88.

Baker, H.K. and English, P., 2011. Capital budgeting valuation: Financial analysis for today’s investment projects (Vol. 13). John Wiley & Sons.

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.

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

Brunzell, T., Liljeblom, E. and Vaihekoski, M., 2013. Determinants of capital budgeting methods and hurdle rates in Nordic firms. Accounting & Finance, 53(1), pp.85-110.

Cooper, W.D., Cornick, M.F. and Redmon, A., 2011. Capital budgeting: A 1990 study of Fortune 500 company practices. Journal of Applied Business Research, 8(3), pp.20-23.

Chai, T.J., 2011. The impact of capital budgeting techniques on the financial performance of courier companies in Kenya. Research Project University of Nairobi.

Daunfeldt, S.O. and Hartwig, F., 2014. What determines the use of capital budgeting methods? Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), pp.101-112.

Ghahremani, M., Aghaie, A. and Abedzadeh, M., 2012. Capital budgeting technique selection through four decades: with a great focus on real option. International Journal of Business and Management, 7(17), p.98.

Hasan, M., 2013. Capital budgeting techniques used by small manufacturing companies. Journal of Service Science and Management, 6(01), p.38.

Hise, R.T. and Strawser, R.H., 2013. Application of Capital Budgeting Techniques to Marketing Operations. Readings in Managerial Economics: Pergamon International Library of Science, Technology, Engineering and Social Studies, p.419.

Maroyi, V. and van de r Poll, H.M., 2012. A survey of capital budgeting techniques used by listed mining companies in South Africa. African Journal of Business Management, 6(32), p.9279.

Rossi, M., 2014. Capital budgeting in Europe: confronting theory with practice. International Journal of Managerial and Financial Accounting, 6(4), pp.341-356.

Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.

Steps encompassed in Sensitivity Analysis usage