Explain the following concepts in relation to Capital Budgeting Techniques.
a. Sensitivity Analysis
b. Scenario Analysis
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The sensitivity analysis is part of the management accounting that is used by the top management in decision-making process. The sensitivity analysis is used for analyzing impact of censorious and non-censorious factors and variables on financial gain of the company. The sensitivity analysis discern the critical factors and admonish the management about that ensure the effective corporate decision-making by the management (XD, 2015). This analysis method helps in identifying that which variables is highly sensitivity and which is low that helps in directing the monitoring to ensure the effectively achievement of the organizational mission and vision.
Furthermore, generally top management uses the sensitivity analysis in the process of capital budgeting to find out the possible relation between the variables such as proposed project, sales of the company, profitability of the company, liquidity condition, contribution, and working capital management of the company (Bierman and Smidt, 2014). Sensitivity analysis with the capital budgeting techniques helps in identifying the possible result to be happened with the project. Hence, the sensitivity analysis is very effective tools in corporate decision-making. In sensitivity analysis, the estimated value in calculation is changed to see the impact on the financial aspects of the project. The management is better able to analyze the project by incorporating the sensitivity analysis in the capital budgeting process (Chron, 2017).
Moreover, the sensitivity analysis is the method analyzes the changes in the net present value and internal rate of return of the project due to change in the variables. Sensitivity analysis first identify the factors or variables that have influence on the NPV of the project, defining the underlying relation between variables, and then changes in the variables to analyze the impact of change on the NPV of the project (Daunfeldt and Hartwig, 2014). Overall, it means that sensitivity analysis finds out the changes in NPV due to changes in the input variables, which is used to calculate the NPV. The input variables may be discount rate, tax rate, cash flow growth rate, change in depreciation method, and others.
For example, a company namely XYZ wants to invest in a project for business expansion. The project requires investment of $50000. The cash inflow is estimated about $15000 per annum. The company estimated discount rate of 10%. The NPV, ARR, and Payback period, IRR will be calculated based on these variables and produce result accordingly. The NPV of the project is $6,861 of the project. But if the discount rate is increased to 15% than the NPV of the project decrease that is $282.33 only. Therefore, it can be said that sensitivity analysis is the accounting tool, which is included by the management to assess the impact of the change in inputs variables on the output of the project. Overall, it can be said that the sensitivity analysis is the techniques of the capital budgeting to be used by the management for availing the insights into the project that helps in analyzing the risk and variation with the project (Bierman and Smidt, 2014). This helps in better decision making the management.
Scenario analysis is another approach similar to sensitivity analysis which examines the risk in a particular scenario. Scenario analysis is used by the decision maker in management to evaluate the potential outcomes with respect to different alternates for getting the better investment results (Baker, and English, 2011). At the same time, it is used in capital budgeting management to assess the risk for business. Scenario analysis examines the potential results of capital budgeting in a project's net present value. In an investment more than two or three options available to evaluate the risk. Capital budgeting is a process that determines the potential outcomes by investing in a project. Scenario analysis measures the cash flow and value of asset under various scenarios in future (economicstimes, 2017). Outcomes of scenario depend on the variability in cash inflow, cash outflow and cost of capital. The assumed scenario cannot be resulted into the exact variable it depends on changes in npv, interest rate and inflation. Scenario analysis is used by the management of corporate to take worthy decision on the basis of present scenario of variables Majorly these assumptions are useful in calculating the total risk. Moreover, it is an analytical tool to assess the uncertainty for current project. At the same time, it identify the probable results on the basis of differ variables.
Further, changes in variable mostly resulted into the bad scenario, which directly impacts the expected results. From this analysis, two other expected variables are measured one is best and another is worst case. At the same time, value of NPV lies in between these two potential expectations. Further the changes in variables are measured with respect to the NPV and IRR (Yoe, 2016). Generally, the top management uses these techniques to assess the potential outcomes on the basis of variables. If the variable in an scenario are changing due to the factors such as internal rate of return and inflation that directly impacts the corporate decision makers to reassess the results and use the best practice of investment variables.
For instance, if a company is having the business of road construction and it contracts with the government to build 200 kilometer road. For this project, the expected net present value is determined as $70 million. For this project, company estimates the cost of capital as 6% and the cash inflow as 15 million at the end of 1 year and the annual expenditure is for 3 year as $30 million. For the best case and worst case the scenario is changed. For the best case scenario, assume cost of capital as 4.5%, cash inflow $20 million at the end of one year and the cash flow for second and third year is as $25, $30 million respectively. On the other hand, the worst case scenario is assumed the cost of capital as 8%, cash inflow $10 million at the end of one year.
For the best case scenario, net present value is $110 million and for the worst case scenario npv is $35 million. From this scenario analysis it is found out that the net present value is expected to be between $110 million and $34 million with the most likely figure to be $70 million. So it is assessed that the management would take the decision for the available alternative which would be less variable.
Baker, H. and English, P. (2011) Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. USA: John Wiley & Sons.
Bierman Jr, H., & Smidt, S. (2014). Advanced capital budgeting: Refinements in the economic analysis of investment projects. UK: Routledge.
Chron, (2017). Sensitivity analysis for capital budgeting. Retrieved from http://smallbusiness.chron.com/sensitivity-analysis-capital-budgeting-10153.html.
Daunfeldt, S. O., & Hartwig, F. (2014) What determines the use of capital budgeting methods? Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), 101-112.
Economictimes, (2017). Definition of 'Scenario Analysis'. Retrieved from: http://economictimes.indiatimes.com/definition/Scenario-Analysis
XD, (2015) Sensitivity analysis. Retrieved from http://xplaind.com/167040/sensitivity-analysis.
Yoe, C. (2016). Principles of Risk Analysis: Decision Making Under Uncertainty. USA: CRC Press.