Capital Budgeting Techniques

Discuss About The Investment Analysis Financial Management?

The decision of the management is the most critical in ascertaining the main basis of the establishment of the business. So it must be clear that the decisions made by the management should be perfect and there should not be any flaws in the decision making. If any flaw would remain in the decision of the management then it could lead to bad impact on the profits and losses of the organization. The most appropriate option should be selected so that the management can get the desired results keeping in mind the factors affecting the goal of the management. Since the business environment in today’s world is dynamic in nature hence only a decision keeping in mind a particular goal cannot be implemented. The result should be continuously evaluated so that the decision proves to be correct one and the desired results can be achieved (Berman, Knight and Case, n.d.).

Usually there are two types of decisions taken– top down approach or the bottom down approach. Depending on the type of decision the management is taking either of the two approaches is used. Although the decisions of the management is necessary to attain a particular result but the execution of the decision is more important for achieving a particular goal. It is important for the management to keep a healthy relationship with the lower level and the middle level management so that the decisions can be executed in the best possible manner. If the lower level or the middle level management does not function properly then any best decision in the world would not be successful hence there must be continuous good relationship with all levels of the management so that each and every person in the organization could feel the responsibility of the work given and function properly (Shim and Siegel, 2008).

The management while making its decisions must keep in mind that it needs to make best use of available resources. But in most of the cases the decision of the management gets struck by the availability of the capital hence the management uses the capital budgeting method in order to get the best return with the available resources.

Capital budgeting can be done using various techniques. They are discounted cash flow method, internal rate of return method, net present value method and payback period. These methods are described as follows:

Sensitivity Analysis

Discounted Cash Flow method (DCF method): In this method, the future cash flows are discounted to their net present values by using cost of the capital so that the present value of the investments can be evaluated. The main purpose is to identify the time value of money by discounting the future cash flows (Bruner, Eades and Schill, 2017).

Internal Rate of Return method (IRR method): In this method the net present value from all the cash flows from a particular project is made zero by using a discount rate. This method is used to determine the potential of a particular project. The formula used for internal rate of return method and the net present value method is same. If the internal rate of return derived is greater than the rate of return the organization desires then the company will move ahead with the project however if the rate of return derived is lesser than the rate of return the organization desires then the company will forego the project and will not invest its money in the project (Saltelli, Chan and Scott, 2008). The calculation of the internal rate of return is as follows. The same example is also used for the net present value method:

Net Present value method (NPV method): Net present value is basically difference of the present value of the cash inflow and the present value of the cash outflow. A project with a positive net present value will be taken and with a negative one will be foregone. For example: In case of two assignments A and B where the required rate of return is 10.25% and with different cash flow structures, the net present value of the cash flows will be shown as below:

Discounted payback period: Breaking down the starting expenditure by scanning future cash flows and monetary time values are steps of a capital budgeting method which is discounted payback period (Taylor, 2008). According to this, if a project is to be undertaken by the company then the target period must be greater than the discounted payback period which is calculated.

Evaluation of values from different types variables are taken into consideration in this type of analysis. Alteration in the dependent variables with a change in the independent variables is recorded by an analyst in accordance with some constant circumstances. Also known as “What if analysis”. This analysis is useful for both corporate and personal level decisions. The main business of t6his analysis is to record the alteration in the output value in accordance with a change in an input value while keeping all the other inputs constant (Galbraith, Downey and Kates, 2002).  

• Evidence should be present for as the base case output; like NPV at a particular base case input value (V1) for which the sensitivity needs to be measured after having all other inputs constant.
• All the input values must be kept aside and a new value must be undertaken to evaluate the output.
• After the above processes the %change in both input and output must be evaluated.
• Dividing the %change in output with the %change in input will reap the final amount of sensitivity.

Scenario Analysis

As per the evaluation made, it is clearly evident that if the value of the sensitivity is higher, then the output will be more influenced by any alterations in the input value or the opposite case may be.

Process related to the evaluation of the “estimated value” in accordance with the alteration in the key factors such as interest rates, etc for a fixed span of time is referred to as scenario analysis. Calculation of various reinvestment rates is the main work of this analysis with which maximum profit can be attained by the company. All this scanning and reporting is done by a professional analyst. Values of various portfolios keeps on changing as per the changes in the environment and this analysis helps in its detection as to follow the principle of “What if analysis”. While investing in a particular project, it is advised to use this form of analysis to have a vision of all the ups and downs range probability of the project which keeps on changing and thus increases the threat of irreversible investment or grave loss. Thus, this analysis detects the flaws and the risks of the project at an early stage so as to prevent the losses which can be suffered buy the investor (TULSIAN, 2016).

Standard deviation of the monthly or daily security returns can be regarded as the best process to grab the scenario analysis technique. The above procedure evaluated the value of a current portfolio. This analysis provides the analyst with a satisfactory reason as of why the value of the portfolio has been subjected to alteration.

There exists some differences between the two above mentioned analysis and they are not at all similar to each other. This can be understood by a simple example like; if an equity analyst is keen enough to record the impact of both the sensitivity and the scenario analysis on Earning per Share(EPS) then he will have to evaluate it through the given data of earnings(P/E) multiple (Holland and Torregrosa, 2008).

If in a span of accounting period a company undertaken a project which included expenses and then he company carries on with its work to gain surplus capital which can nullify the expense, then in that case it is said Break even analysis. So it is clear that there will be no gain or loss and thus the net income of the company will be zero. This analysis acts as a boon to clarify the amount of sales which must be made by the company so as to nullify all the expenses though the net income of the company will be zero (Khan and Jain, 2014).Accounting Breakeven analysis: Accounting breakeven analysis occurs when the net income is zero. This can only happen if the total revenue or capital gained is similar and equal to the total expense of the project. This can be achieved when we calculate the ratio of variable cost to sales. Taking an example, if there is a given ratio of 0.65 then this states that with every rupee of sales of each unit, the contribution is 0.35. Thus, the contribution margin ratio comes to 0.35.

Breakeven Point = (Fixed Cost + Depreciation) /Contribution Margin Ratio. Non addition of the depreciation leads to the breakeven point to be known as the cash breakeven point. Zero returns on the sale clearly depict that that a particular value has been in contact with the breakeven point. As there in no profit in the project so the money which is invested by the company will be recovered with no additional amount (Reilly and Brown, 2012).   ·         Financial breakeven point: If the initial investment is found to be similar to the cash flow then the NVP breakeven occurs. When the net present value is equal to zero then the analyst has to be provided with the transaction related to the amount of sales so as to evaluate the final breakeven point.  ·         

 The term simulation refers to the duplication of a condition or method. Monte Carlo simulation can be thought of as the analysis of the methods that have been copied from the original ones or can be defined as the analysis of the key features of the system of random numbers by the process of duplication. Adding up of the advantages with the ones of the capital budgeting can be thought to be possessed by the simulation analysis as it gives the analyst a clear vision of the risk that prevails in the project. This analysis also keeps a track record of all the alteration being made in different variables of the company.

• Variables need to be categorized for both cash outflows and also for inflows.
• Every variable related formula must be highlighted and evaluation of probability distribution for every individual variable should be done.
• Installation of a computer program so as to select a value from every probability distribution of each variable should be done so as to finalize the successfulness or failure of a project by analyzing such values.
• The result of this calculation is not a small value but it is rather a profitability distribution of all the feasible expected returns.

A list of limitation for the capital budgeting prevails in the system though it is important for decision making processes.

• Inapt and mysterious investments arises difficulty in the preparation of perfect budget.
• It is advised that all the decisions should be seriously scanned because they comprise of heavy amounts which are irreparable in nature

Conclusion

From the above assignment we have come to know various techniques and the importance of capital busgeting which are summarised below:

• Evaluation of the risks: Threats prevails in any long-term investments which are termed as capital costs. Capital budgeting provides the company a safe and secure way to get hold on such expenses (Clarke and Clarke, 1990).
• Finding the best course of action: This provides the firm with all possible probability of investments from which the company can easily choose the most profitable one. Its main target is to provide profits to the shareholders and thus to increase the dominance and respect of the company in the market.
• Long run of the business: Reduction in the expense with an increase in the profit at the same time can be sensed while using capital budgeting. This technique makes the company a long race horse while shielding it against abrupt investments. Also helps in analysis, assessing appropriate arrangement (Fairhurst, 2015).
• Irreversible investments: Some projects require massive funds to be borrowed by the company. In such cases the project must be thoroughly scanned and then only any investments should be carried because such investments once made have no chance of getting refunded.

References

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Clarke, R. and Clarke, R. (1990). Strategic financial management. Homewood, Ill.: R.D. Irwin.

Fairhurst, D. (2015). Using Excel for Business Analysis A Guide to Financial Modelling Fundamenta. John Wiley & Sons.

Galbraith, J., Downey, D. and Kates, A. (2002). Designing dynamic organizations. New York: AMACOM.

Hassani, B. (2016). Scenario analysis in risk management. Cham: Springer International Publishing.

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Khan, M. and Jain, P. (2014). Financial management. New Delhi: McGraw Hill Education.

Palepu, K., Healy, P. and Peek, E. (2016). Business analysis and valuation. Andover, Hampshire, United Kingdom: Cengage Learning EMEA.

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Reilly, F. and Brown, K. (2012). Investment analysis & portfolio management. Mason, OH: South-Western Cengage Learning.

Saltelli, A., Chan, K. and Scott, E. (2008). Sensitivity analysis. Chichester: John Wiley & Sons, Ltd.

Saunders, A. and Cornett, M. (2017). Financial institutions management. New York: McGraw-Hill Education.

Shim, J. and Siegel, J. (2008). Financial management. Hauppauge, N.Y.: Barron’s Educational Series.

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TULSIAN, B. (2016). TULSIAN’S FINANCIAL MANAGEMENT FOR CA-IPC (GROUP-I). [S.l.]: S CHAND & CO LTD.