Sensitivity Analysis

Discuss about the Process Of Decision Making.

The management of the company is faced with a challenging task of taking decisions. Therefore, it is imperative that the management must have strong skills and mechanism that will aid in the process of decision making. In this assignment, the major emphasis is on the usage of techniques such as scenario, sensitivity, break-even and simulation. The assignment even sheds light on the manner the decision making is impacted by the use of such techniques. Mainly it stresses on the capital budgeting technique.

Force and difficulty are the two key factors under which a business functioning takes place. Time has passed on and with that, the market has seen a significant change in the key factors of business functioning. Internal and external factors both are equally essential for the business functioning. Internal policies, management, etc are the forms in which internal factors exist. Whereas, the framing of new policies, changes in demand pattern, etc are the forms of external factors. It is impossible to control the external factors and as a result, the profit of the company gets affected. Thus, to avoid and eliminate such situations, the company can follow an efficient process that proves to be a boon in assessing the sensitivity of the sales, cost and the alterations in the income pattern. This method is termed as a sensitivity analysis. It is an analyzing process which helps to view the changes in the variables, and also it is a scientific method to see the practicability of the particular project. The unfavorable changes and alteration are the ones that are taken into utter consideration under this process and are treated so as for be known as the prosperity of the venture. Sensitivity analysis forms a major part of the Capital Budgeting (Peirson et. al, 2015).  It increases the visibility factor against the key variables that affect the cost and venture assistance. This process helps to trace cost pertained operations in these stages. It gives a firm view of the changes and also depicts whether the changes would be favorable for the company or not.

A boon that exists to provide the company a clear view of the changes and, whether those will be favorable for the cash flow and the venture assistance or not is generally known as Sensitivity analysis. The main target of the sensitivity analysis is not the evaluation of risks. The receptiveness of the NVP is the main matter of concern in a sensitivity analysis, much more than risk evaluation. It proves to be a boon for the particular manager so as to decide the perfect strategy as per the situations and essential reasoning on the other hand which helps to explain the fact that under which circumstances, the venture stood up as a successful plan. Alterable assumption or estimation of a project is covered by this method in capital budgeting (Brealey et. al, 2015).  

Sensitivity Analysis in Capital Budgeting

Number of selling units, project completion time, cost of capital and many more factors are to be paid attention whenever a capital budgeting decision is being taken. In these cases, it is necessary that the assumptions being considered are well stated and valid. The success of the sensitivity analysis is made in terms of the result attained to the assumption made at the initial stages of the venture (Petty et. al, 2012). Sensitivity analysis alters some assumptions while keeping others stable and ascertains the alteration in NVP or IRR.

Scenario analysis can be defined as a process that helps in evaluating a specific project by taking into consideration various assumptions and factors. Specifically, scenario analysis can be stated as a mechanism that helps in evaluating a project by knowing different situation or scenarios. Through scenario analysis, it is easy for the management of the company to assess every alternate outcome of any project that comes in the way. It is famous for ascertaining the scenario that is worst and helps in predicting the losses and other issues that emerge in the operations (Da, 2012). The process can be a strong guide to know about the fall in sales and lays a strong foundation when it comes to the process of capital budgeting. In short, this method can be used in terms of evaluation.  An apt example of this mechanism is when the manager creates a budget but is not certain of the revenues or the income. The part of scenario analysis comes to the forefront and enables the manager to know the income possibility and then application of probability analysis is done.  In this scenario, the worst and the best case scenario can be segregated. The best case for the manager will be where the company will fetch a gross income of $1, 50,000  and the cost of goods sold stands at $50,000 hence a gross profit of $1,00,000 can be derived.  Secondly, the worst scenario for the manager will be when the gross income will be $70,000 and the cost of goods sold stands at $30,000. Here, a gross profit of $40,000 can be recorded.  The scenario analysis is a perfect tool in this condition.

As per Correia et. al (2015) when a project is initiated it is vital that the scenario of the project must be studied in an effective manner. When it comes to an investment opportunity then the company must undertake a scenario analysis by tracing the IRR and the NPV by considering various rates of cost of capital. At the same instance, the management can even conduct scenario analysis by tracing the IRR and NPV at different levels.  When scenario analysis is done through capital budgeting mechanism it enables the management to conduct a real time analysis of the project that helps in taking a fast decision (Parrino et. al, 2012).

Scenario Analysis

A very important method known as the break even analysis is used under situations when multiple questions or queries arise in association with the profitability gained due to the product and services of the company. Its use can be linked either with a product or a service. This particular method can be used to answer questions relating to the minimum sales that the company must have so as to help the company survive without any losses on its part and also to lessen the sales of some products while keeping the profits stable (Damodaran, 2012). Break even analysis answers to all the questions in relation to a new project like profit assumption, whether it will have a positive curve or a negative one.    

Break even analysis is important to the manager so as to see that the maintained stock of product or products will adhere to their profitability and volume or not. This method is used whenever a company wants to set up a breakeven point so as to show the net income as zero and in order to do so, the company has to ensure whether their stock is in association with the cost of the company and this can be done by the break even analysis. It provides a healthy understanding in the terms of variable and fixed cost. The validity of the project is determined by capital budgeting but break even depicts the profit making percentage of the project undertaken (Graham & smart, 2012). It is required to set up firm and targeted break even analysis on a new project while deciding its finances so as to get a vision of the project in the future which states its efficiency and successfulness. The manager should be familiar with the break even analysis so as to decide accurate strategy and take the perfect decisions. The forum for the break even stands:

BEQ FC / (P-VC)

Where BEQ = Break-even quantity

FC = Total fixed costs

P = Average price per unit, and

VC = Variable costs per unit.

(Pratt: 2016)

In order to have a view to the risky functions, pre determination of the probability distribution and the random numbers is made and all this is done on the basis of simulation. Usage of the mechanism of the cash flow is done in a very mathematical way with several repetitions to undertake the process (James, 2010). All this is performed by the manager of the venture. Increase in the probability distribution can be seen as a resource of this undertaken process which is predictable. This process is a boon for the manager as he gets a clear value of the probability distribution for cash inflow and the generated random numbers so as to assign values to different variables. When such values are taken into account and recorded then it results in NVP (Abor, 2017). The probability distribution of the net current value is easy to be calculated if the same above process is repeated countless times by the manager of the venture.

Break-even Analysis

As per James (2010), an analysis of the cash flow is hard and if it is discounted then it is very difficult to get hands on it. This stress is easily solved by the process of simulation as it a powerful spreadsheet which helps the manager in these risk evaluation activities. All the future circumstances regarding the project are easily visional with simulation as it provides a clear view of the alteration of the variables in the future. It also possesses solutions for those loopholes which are prominent in sensitivity analysis and this makes simulation better than sensitivity analysis. Simulation fails to set an example and arrive at any particular decision which is practical in nature and ends with real life. This is because the simulation is a method which follows a series of mathematical calculations of variables whose values taken into account are the one as per the records of the previous years and the values keep on changing with time.  The use of simulation made by the managers is done in a multiple numbers of steps. Important values and their assessment are all done by the simulation process followed by the manager, all this comes under the topic of modeling and this includes a whole lot of mathematical functioning (Abor, 2017). A defined particular probability value always exists for all the important variables that exist either individually or as a base joined with any previously observed data. Also, it is obvious that the utilization of computer has made the process of simulation easier. The result of the calculations made by simulation is of great significance to the managers as its gives a thorough knowledge about future aspects and helps in decision making and also to evaluate the risk that follows instead of a defined tip assumption. Thus, it can be said that a practical view is provided by simulation to the managers to know the selectivity of the venture (Petters & Dong, 2016). The most important plus point of the simulation is that it provides innumerable venture estimates. For instance, a selected project of 99% positivity and IRR more than the cost of capital can always prove to be a very fruitful project as the project ensures high return with very minimal chances of failing. But on the other hand, it is also to be seen that massive project with beneficial return has much more risks (Guerard, 2013). Thus, it is prominent that no NVP can touch the 100% mark as the ventures that earn the cost of capital are risky also. Thus, the process of simulation can be helpful to the managers to view and highlight the inventor’s predisposition in respect to the particular venture.   

Conclusion

From the above study, it is clear that the management of the company can use a variety of methods for ascertaining a project. It is upon the management to use the method as per their suitability and determine whether a particular project must be selected or not.  The feasibility of the project can be known with the aid of capital budgeting mechanisms like IRR and NPV.  The study indicates that the utilization of the method is as per the demand of the situation and as per the need. However, the presence of various method is a benefit to the management while making crucial decisions.

References

Abor, J.Y 2017, Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs, Springer International Publishing.

Brealey, R. A, Myers, S. A & Marcus, A. J., 2015, Fundamentals of Corporate Finance, 8th ed, Australia: McGraw-Hill Irwin.

Correia, C, Mayall, P, O’Grady, B & Pang, J., 2005, Corporate Financial Management, 2nd ed. Perth: Skystone Investments Pty Ltd.

Da, Z, Guo, R.J. & Jagannathan, R 2012, ‘CAPM for estimating the cost of equity capital: Interpreting the empirical evidence’,  Journal of Financial Economics vol. 103, pp. 204–220

Damodaran, A 2012,  Investment Valuation,  New York: John Wiley & Sons.

Graham, J & Smart, S 2012, Introduction to corporate finance, Australia: South-Western Cengage Learning.

Guerard, J. 2013, Introduction to financial forecasting in investment analysis, New York, NY: Springer.

James P. D 2010, Topics in Capital Budgeting, viewed  5 September  2017 https://www.csun.edu/~jpd45767/303/8%20-%20Topics%20in%20Capital%20Budgeting.pdf

Parrino, R, Kidwell, D. & Bates, T 2012, Fundamentals of corporate finance, Hoboken

Peirson, G, Brown, R., Easton, S., Howard, P & Pinder, S 2015, Business Finance, 12th ed., North Ryde: McGraw-Hill Australia.

Petters, A.O & Dong, X., 2016, Capital Market Theory and Portfolio Risk Measures In An Introduction to Mathematical Finance with Applications, Springer New York.

Petty, J. W,  Titman, S., Keown, A. J., Martin, J. D., Burrow, M., and Nguyen, H., 2012, Financial Management: Principles and Applications, 6th ed., Australia: Pearson Education Australia.

Prat, R 2016. Five Objections Against Using a Size Premium When Estimating the Required Return of Capital with the Capital Asset Pricing Model. Madimon consulting