FIN200 Techniques in Capital Budgeting Assessment 2 Answer
Any organization is faced with multiple long-term decisions. One of the important long-term decisions that an organization takes is related to investment in projects. This is because if investment is made in wrong projects that lead to losses, it will impact the organization adversely. Also, the funds which are limited in nature will be appropriated to these projects making the organization incapable of selecting any other fruitful projects. Conversely, if correct projects are selected, it will improve the profitability in long-run. This is the crux of what we call as capital budgeting (Trevor & Fadi, 2005).
Capital budgeting relates to an organization’s long-term decisions regarding investments. As explained above, this is an important aspect for financial health of the company. There are multiple techniques that can be used for capital budgeting purposes. This assignment focuses on four of these techniques, namely, sensitivity analysis, scenario analysis, break-even analysis and simulation analysis. Wherever possible, hypothetical situations and illustrations will be used to further elucidate on the technique.
Sensitivity Analysis is popularly used in a variety of fields, one of them being capital budgeting. It is also used in scientific fields, geographic and biological fields. As the name suggests, the main purpose of Sensitivity Analysis is to ascertain how sensitive a dependent variable is when there are changes in the independent variable. An important aspect while performing analysis is that apart from the change in independent variable, remaining variables and assumptions remain the same (Graham & Harvey, 2001).
Such an analysis can be conducted with the help of MS-Excel that has a tool called ‘What-If’ analysis. In order to understand further, the following pages will discuss a hypothetical situation where Company A is presented with opportunity to invest in two projects, namely Project 1 and Project 2. Both projects have duration of 10 years and cash outflow occurs initially. Afterwards, there is a stream of cash flows during each year as explained in below table:
|Year||Cash Flows ($mn)|
|Project 1||Project 2|
|0||$ -10.0||$ -10.0|
|1||$ 5.0||$ -|
|2||$ 5.0||$ -|
|3||$ 5.0||$ 10.0|
|4||$ 5.0||$ -|
|5||$ 5.0||$ -|
|6||$ 5.0||$ 15.0|
|7||$ 5.0||$ -|
|8||$ 5.0||$ -|
|9||$ 5.0||$ 15.0|
|10||$ 5.0||$ 20.0|
As can be seen, there is outflow of $10 million initially and then cash flows occur periodically. While in Project 1, there is consistent stream of cash flows, Project 2 provides cash flows every two years and then a lump sum amount. The Company can select only one of the projects and needs to identify the correct option basis Net Present Value Method (NPV). This requires a discount factor to discount cash flows. Currently, Company A has average cost of capital of 8% and hence, decides to use it as the discount factor. The result is as follows:
|Year||Cash Flows ($mn)|
|Project 1||Project 2||Discount Factor = 8%|
|0||$ -10.0||$ -10.0||1|
|1||$ 5.0||$ -||0.925926|
|2||$ 5.0||$ -||0.857339|
|3||$ 5.0||$ 10.0||0.793832|
|4||$ 5.0||$ -||0.73503|
|5||$ 5.0||$ -||0.680583|
|6||$ 5.0||$ 15.0||0.63017|
|7||$ 5.0||$ -||0.58349|
|8||$ 5.0||$ -||0.540269|
|9||$ 5.0||$ 15.0||0.500249|
|10||$ 5.0||$ 20.0||0.463193|
|NPV||$ 21.81||$ 22.37|
It can be seen that NPV is higher for Project 2 and should be selected. However, Company A is unsure of discount factor of 8% is correct and wants to analyse the impact of change in discount factor on the NPV of each project.
As mentioned earlier, this can be done using MS-Excel with the help of an in-built tool called ‘What-If’ analysis. The calculations were performed in MS-Excel at various discount rates, such as 6%, 10%, 12%, 14% and 16%. The result was as follows:
|Discount Factor||Project 1||Project 2|
|8%||$ 21.81||$ 22.37|
|6.0%||$ 25.28||$ 27.37|
|10.0%||$ 18.84||$ 18.23|
|12.0%||$ 16.30||$ 14.79|
|14.0%||$ 14.11||$ 11.92|
|16.0%||$ 12.21||$ 9.52|
It can be seen that as the discount factor increases, NPV for both the projects reduces but Project 1 becomes a better option due to higher NPV as compared to Project 2.
The Company still wants to see if the analysis holds weight and hence, we can see percentage change in NPV as compared to the base case when discount factor was 8%. This is as follows:
|Discount Factor||Project 1||Project 2||Project 1 % Change||Project 2 % Change|
It can be seen from above table that NPV of Project 2 seems to be much more sensitive to changes in discount rate factor as compared to Project 1. This is the reason that the NPV for Project 2 has fallen drastically with the increase in discount rates. Hence, the Company can now take a decision accordingly whether it wants to select Project 1 that is less sensitive to changes and will provide higher NPV at higher discount rates. Or, the Company can select Project 2 if it expects that the discount rate will remain less than 10%.
As the name suggests, Scenario Analysis is a technique of capital budgeting that helps in analysing future events under various conditions. Each of the possible outcomes represents a scenario. The scenarios can be created based on changes in one or more variables such that the final outcome gets impacted (Hassani, 2016).
A very frequent usage of the technique is when an organization wants to visualise best case scenario (or optimistic) and worst case scenario (or pessimistic). This can be done using the feature called ‘Scenario Manager’ in MS-Excel.
Let’s assume that the Company A is launching new product in the market and is forecasting the revenue and cost numbers for the initial year. The initial capital expenditure for setting up the product line is $1 million which will be depreciated @$200,000 per year for five years. The relevant data is in table below as follows:
|Annual Depreciation||$ 2,00,000|
|Sales Price||$ 25|
|Variable Cost||$ 12|
|Fixed Cost||$ 1,00,000|
The Company has identified the factors in yellow as the factors that it wants to change by 20% and see the impact on Net Profit. The calculations can be represented as follows:
This table presents the calculations for Net Profit as well as change percentage that the Company wants to set in the Scenarios.
Hence, for a pessimistic case, the sales price and volume will decline while the variable cost will go up. The result is as follows:
|Sales Price/unit||$ 20.00|
Hence, for an optimistic case, the sales price and volume will incease while the variable cost will decline. The result is as follows:
|Sales Price/unit||$ 30.00|
The information for above two scenarios was plugged into MS-Excel tool ‘Scenario Manager’ and the Scenario Summary was generated as follows:
|Sales_Price_unit||$ 25||$ 20||$ 30|
|VC_unit||$ 12||$ 14||$ 10|
|Notes: Current Values column represents values of changing cells at|
|time Scenario Summary Report was created. Changing cells for each|
|scenario are highlighted in gray.|
It can be seen that under the Pessimistic Scenario, the Company is unable to earn profit and incurs a loss of $76,000 in initial year. However, under the optimistic scenario, the profit increases almost three times as fixed costs have already been recovered in base scenario which leads to higher profits at higher volumes.
The Company can take decisions regarding the three main variables basis the above scenarios.
Under capital budgeting, probably break-even is one of the most popular techniques as it is straight forward to calculate and very useful. As the name suggests, breakeven point helps a company to analyse the point where it is breaking even. In other words, the point of sales where company is able to recover all its costs is known as the breakeven point. This also leads to corollary that any sales after reaching the breakeven point will lead to profits for the organization or indicates positive returns (Correa, 1984).
For the purpose of calculating breakeven point, it is required to understand the two main types of costs, namely fixed costs and variable costs. Variable costs are those that vary or change with a change in number of units. However, the fixed costs remain the same irrespective of the level of production.
|Units||Variable Costs||Fixed Costs||Total Costs|
|750||$ 18,750||$ 25,000||$ 43,750|
|1,000||$ 25,000||$ 25,000||$ 50,000|
|1,250||$ 31,250||$ 25,000||$ 56,250|
|1,500||$ 37,500||$ 25,000||$ 62,500|
|1,750||$ 43,750||$ 25,000||$ 68,750|
|2,000||$ 50,000||$ 25,000||$ 75,000|
|2,250||$ 56,250||$ 25,000||$ 81,250|
It can be seen in the example above that there is a variable cost of $25/unit which changes as the number of units change. It increases as the units increase. On the other hand, the fixed cost remains same at all levels of production. The total of variable cost and fixed costs provides total costs. Hence, it is clear that at 0 level of production, variable costs will be zero but fixed costs will be same at $25,000. The graphical representation is below:
Now, let’s assume a sales price of $45/unit and calculate total income at various levels:
|Units||Variable Costs||Fixed Costs||Total Costs||Income|
|750||$ 18,750||$ 25,000||$ 43,750||$ 33,750|
|1,000||$ 25,000||$ 25,000||$ 50,000||$ 45,000|
|1,250||$ 31,250||$ 25,000||$ 56,250||$ 56,250|
|1,500||$ 37,500||$ 25,000||$ 62,500||$ 67,500|
|1,750||$ 43,750||$ 25,000||$ 68,750||$ 78,750|
|2,000||$ 50,000||$ 25,000||$ 75,000||$ 90,000|
|2,250||$ 56,250||$ 25,000||$ 81,250||$ 1,01,250|
It can be seen that at production level of 1,250 units, total costs are equal to income at $56,250. This indicates that costs have been recovered at this level and going forward, the organization will earn positive returns. This can be seen in income which is greater than total costs after 1,250 units level. This is presented graphically below:
Further, sales price minus variable cost/unit indicates contribution/unit or contribution towards recovering the fixed costs. In total terms, revenue minus total variable costs gives contribution. A way of calculating breakeven point is to divide fixed costs by contribution (Correa, 1984).
In above example, if we divide the fixed cost of $25,000 by contribution (sales price minus variable cost or $20/unit), we arrive at the same number of units, which is 1,250 units. If the organization is selling more than 1,250 units, it will earn profits or positive returns. This also leads to conclusion that if the organization is selling less than 1,250 units, it will incur losses.
A Simulation involves use of computer to create a model that can run the same scenario multiple times by inducing uncertainty in cash flows through use of probability. This uncertainty can be introduced by use of random numbers or RAND() function in MS-Excel.
Typically, this technique is used for very large projects as it involves estimating probability of various cash flows. The use of technique helps the organization to estimate cash flows with more accuracy (Salazar & Sen, 1968).