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Finnce And Capital Budgeting Techniques Ã¢â¬ MyAssignmenthelp.com
Question: Discuss about the Finnce And Capital Budgeting Techniques. Answer: Capital budgeting techniques Capital budgeting is considered to be a process of planning that usually used to establish whether an organization's long-term investments like replacements of equipment, new machinery, new products, new plants and research improvement projects are worth support of cash via the company capitalization plan (Andor, Mohanty, and Toth, 2015). Capital budgeting is primarily one of the areas that have basically attracted a lot of academic attention in the last decades, and a lot of descriptive literature has emerged in as a management accounting technique. Capital budgeting decision is of strategic significance not only for the development of the company but also for the overall growth of the overall economy because such diverse decisions basically involve the company committing limited productive resources to its systems of production as they renew or strengthen their resources. Therefore, the aspect of capital budgeting involves how diverse resources must be allocated to the organization so as to maximize the stakeholder's wealth (Burns, and Walker, 2015). It involves a commitment of large amounts of funds in a provided project, or investment and such decisions are often complex to reverse without disturbing the firm financially and economically. In this case, capital budgeting practice is considered to be one of the important inputs of investment decision-making process of working on diverse projects or investments. According to Chittenden, and Derregia (2015), capital budgeting practice is employed so as to make diverse decisions in investments in long-term assets such as plants, properties, equipment, designs, and trademarks. Capital budgeting techniques are stipulated decisions rues that guides the managers on how to make investments or projects decisions since they are usually measures of the investments or projects economic and desirability feasibility. Various capital budgeting techniques have been gradually developed over time. Because the future is basically full of uncertainties, managers should scan the environment in which they operate in. Diverse factors often affect the forecasted cash flows, and they include; inflation, risks, uncertainties and the discount rate. The most generally recognized and used techniques are basically grouped into two major classifications. Conventional techniques Discounted cash flow techniques Conventional techniques are considered to be those techniques that do not consider the time worth of cash flows and they include the Accounting Rate of Return and the Pay Back Period. On the other hand, the discounted cash flow techniques are considered to be those techniques that basically consider the time worth of the cash flows and they encompass the Probability Index, Net Present Value and the Internal Rate of Return. However, the Pay Back Period has been modified at least to consider the time worth of money but, still it has the problem of not recognizing the cash flows after the Pay Back Period (Brunzell, Liljeblom, and Vaihekoski, 2013). Discounted cash flow techniques basically do not offer the methodology for measuring the value or worth of real options since the value derives from the aspect that diverse managers have the right to make on going favourable decisions that concerns the investment and subsequent operations of the investment or the project. Capital budgeting ba sically comprises of diverse techniques utilized by company executives such as; Pay Back Period Technique Pay Back Period basically measures the time length that it takes a firm to recover the cash in original venture. This notion can also be elucidated as the basic length that a project or investment takes in order to produce cash equals to the project and pay the organization back (Ghahremani, Aghaie, and Abedzadeh, 2016). Pay Back Period is usually evaluated by dividing the resources investment by the net yearly cash flows. In this case, the petite the Pay Back Period, the faster the organization recuperates its cash investments. Net Present Value (NPV) Net Present Value is considered to be the worth of the present amount of cash in contrast to some future worth that will contain when the amount is capitalized at a compound interest. It is basically a measurement of revenues calculated by subtracting the current value of the fund flows that included the initial costs from the present values of the cash flows over period of time (Gitman, and Maxwell, 2011). This particular technique is usually used to determine the present worth of a project by the discounted amounts of cash flows that is received from the investment or the project. This particular technique is vital for managers because it basically considered the time worth of money and favours the ultimate aim of organization of maximizing the shareholders wealth and increasing the company share price. Internal Rate of Return (IRR) Internal Rate of Return is a technique that basically uses the present worth of fund flow concepts. This technique basically defines the interest yield of the projected capital investment at which the NPV equals to zero which is where the present worth of the net fund flows equals the venture (Rossi, 2015). In this particular case, if the IRR is considered to be greater than the company required rate of return, then the project may be accepted and rejected if its IRR is not more than the essential rate of return because it is unprofitable. Managers often employ this particular technique in order to determine the project effectiveness. Probability Index (PI) Probability Index technique is the ratio of the present worth of the future money flows of a project to its original project that is required for investment. This technique measures the present value of the returns that is derived from each of the invested amount that will basically demonstrate the relationship that exist between benefits and the cost of the project (Schlegel, Frank, and Britzelmaier, 2013). Probability Index technique is usually useful to the company managers because it will assist them determine the ratio of the future cash flows of the projects anticipated to be invested. Sensitivity Analysis Sensitivity Analysis is one of the technique developed to address the capital budgeting decisions problems. Sensitivity Analysis helps in measuring the sensitivity of a decision to the changes in the variables of one or more parameters. It examines the changes in the projects Net Present Value for a provided variation in one of the variables. Sensitivity Analysis also shows how profound the projects IRR or NPV are to the changes in a particular variable (Bierman and Smidt, 2012). The technique basically investigate the aspect that can happen to the Net Present Value only when one variable is changed as it assists managers identify the margin of safety for each factor identified. In the Sensitivity Analysis other factors that affect are kept constant and the one that varied at a period to see how that factor affects the projected cash flows. Therefore, Sensitivity Analysis is basically referred to as the technique that is utilized to define how diverse values of an independent variable might influence a particular dependent variable in a given set of estimates. 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. The sensitivity is mainly concerned with what if questions such as what if the market share decrease or increase by a certain percentage, what will be the anticipated cash flows (Peel, and Bridge, 2008). Even though this particular technique can basically identify the factors that are considered to be more risky as far as the investment is concerned, the technique does not basically offer a basis of accepting or rejecting the investment or the project. This is because it only shows that a certain factor is more risky than the other and thus one can still do the evaluation techniques in order to choo se the project. Sensitivity Analysis has been proved to be static because it only analyses one factor at a time and this make the managers to depend mostly on their personal judgements (Ghahremani et al. 2016). Even though this particular technique is good but it may need the managers to have more knowledge and skills on how to conduct break even analysis and correlation that may make it hard to be utilized in small businesses especially in the developing states. This therefore may make Sensitivity Analysis less applicable in the developing nations. Steps used in the use of Sensitivity Analysis Identification of all the variables that have effects of the projects Internal Rate of Return or the Net Present Value. Definition of the important correlations in the resultant variables Analysis of the influence of the changes in each of the variables in the Internal Rate of Return or the Net Present Value of the projects (Levin, and Hallgren, 2017). Generally, sensitivity analysis facilitates the organization to approximate what will occur to the investment if the assumptions or the estimates turns out to be unpredictable in case the project do not generate the anticipated results. This technique is of great significance to the company managers because they will contain a clear view point of a particular project before embarking on the investment. Scenario Analysis Scenario Analysis is a techniques that basically evaluates the expected value of the proposed business investment activity. This particular technique is considered to be a strategic practice of exploring diverse decisions by comparing alternative probable results since it is not a predictive tool but an analytic technique to accomplish uncurtaining today (Hasan, 2013). The statistical mean is that the highest probability event expected in a particular situation. Scenario Analysis offers a means to assess the probable inconsistency in a capital budgeting projects Net Present Value. Scenario Analysis calculates numerous Net Present Value for the projects basing on diverse scenarios. Unlike the sensitivity analysis that basically analyses only one factor, the Scenario Analysis analyses all the factors at the same time and find out how the factors affects the expected Net Present Value (Baker, and English, 2011). Scenario Analysis is basically intended to see the magnitudes of an event under different set of elements. For instance, it demonstrate how the Net Present Value of an investment would differ under low and high inflation. In this case, scenarios must be practical enough so as to offer a precise picture of the results because a noble scenario for a manager or a stakeholder must not contain captivating the lottery because even though the prospect is viable, but is neither realistic nor feasible for analyzing the possible outcomes. Scenarios analysis uses three different scenario namely; worst case, best case and base case. The base case is considered to be the probable scenario if all things proceeds typically and this is what the anticipated results will be. The best and worst cases are apparently scenarios that contains more or less favourable settings but they are still restrained by a sense of viability (Hise, and Strawser, 2013). For instance, a cost manager who creates the worst case scenario will not be better served to have it included a disaster that destroys the firm because in a bad situation, it is not convincing enough to be useful. Generally, the aim of the scenario analysis is not only to ascertain the exact situations of each situation, but also it just necessities to estimate them so as to offer a possible notion of what may occur. Scenario analysis majorly focuses on approximating the value of the portfolio that could reduce to if an unfavourable condition of the worst case is basically experienced. The first step in using Scenario Analysis is to determine the NPV or the IRR and then identify all the possible errors of the cash flows and investigate the major effects of their assumptions (Rossi, 2014). This particular technique is offers a means to assess the probable unevenness in a capital budgeting investments NPV for the managers in an organization (Ghahremani et al. 2016). By conduction this particular analysis, managers or investors can produce or generate a risk profile for the predicted projects and then build a basis for comparing probable investment that can facilitate the company productions. Monte Carlo Simulation Analysis Simulation Analysis is considered to be a budgeting technique that basically uses statistical data to figure out the average outcome of a scenario basing on complex and multiple factors. The statistical distribution is approximated for each of the input such as market risks or inflation rates. Simulation Analysis is also considered to be a powerful spread sheet technique that permits diverse executives to better visualize and understand uncertainty and risks in discounted cash flows analysis (Gitman, and Maxwell, 2011). The main output, a histogram of the Net Present Value basically draws the complete distribution of probable results as a bell formed curve and thus estimating the prospect of success of a project. (For example, Net Present Value = Zero). Even though this techniques uses fictional names, managers usually illustrate real capital budgeting problems to demonstrate how using this particular technique can result in a more informed making of decisions. Financetheory basically demonstrates that projected cash flows must be discounted at the opportunity required rate of return using a rule of decision to either reject or accept all negative or positive NPV projects. A central issue for organization managers is how to deal with the aspect of doubt that is the statistic that projected cash flows are only a point approximate of a big amount of probable insights (Chittenden, and Derregia, 2015). Simulation Analysis assist manager of an organization determine the most viable projects because the technique often combines the scenario and sensitivity analysis in analyzing risks in investments cash flows by identifying the main factors that influence the profits and interrelationships. Basically, the cash flows are embedded to demonstrate the main factors that influences both the cash payments and receipts and their interrelationship (Chittenden, and Derregia, 2015). Even though the approach theoretically appear to be good, but in practice the technique may be expensive and complex to be used especially for small and medium enterprises and also in the most developing nations because in needs the use of computer software. Simulation Analysis basically comprises of the following steps; Identify the exogenous variables that influence the cash outflows and inflows of the investment and its IRR or NPV like demand, selling price, market size and the variable costs. Understands the relationship between the NPV and the variables such as revenues relies on sales volume and sales price, sales value depends on the market size and market share (Gitman, and Maxwell, 2011). Specify the probability distribution for each of the exogenous variable Then develop a computer program that randomly chooses one value from the possibility distribution of each of the variable and then use this value in order to calculate the NPV or the IRR of the investment or the project. Break Even Analysis Break Even Analysis is a capital budgeting tool that is utilized to define the opinion at which profit gained equals the value that are associated with gaining the income. It is also a common and most popular technique for analyzing the relationship between profitability and sales volume since a break even aspect often occurs where the total profits equal the total costs, and therefore the revenues are zero (Burns, and Walker, 2015). This technique usually computes what is referred to as the margin of safety where it is the quantity at which the profit surpasses the breakeven point. In this case, Break Even quantity is the amount that profits fall while still remaining above the breakeven point. This particular analysis is important for managers of an organization because it is considered to be a useful tool that facilitates the study of the relationship between variable costs, fixed costs, and returns. Variable costs often vary in direct relationship to output volume while fixed costs are not directly related to the production level. Breakeven points basically defines when a project will produce a positive yield and can be assessed realistically or with modest arithmetics that basically calculates the production volume at a provided price essential to cover all the prices (Cooper, Cornick, and Redmon, 2011). Under the Break Even Analysis, managers of organizations can make an assessment in regarding the probability of not achieving the Break Even sales level. For viable organizations, the lower the Break Even, the safer the projected investment and vice versa. The Break Even Analysis basically works like sensitivity analysis in capital budgeting because the technique emphasizes costs, sales and the price and how they influence on the company profits and revenues. In this case, Break Even Analysis is important for managers when performing capital budgeting because it often facilitates the managers to have a clear point of view of the investment planned to be undertaken that has a shorter break-even period (Rossi, 2015). This technique is also useful to managers during capital budgeting because it demonstrates the amount or the value of the break-even sales in both quantity and value. Bibliography Andor, G., Mohanty, S.K. and Toth, T., 2015. Capital budgeting practices: A survey of Central and Eastern European firms.Emerging Markets Review,23, pp.148-172. Baker, H.K. and English, P., 2011.Capital budgeting valuation: Financial analysis for today's investment projects(Vol. 13). John Wiley Sons. 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