CAPITAL BUDGETING TECHNIQUES

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 Table of Contents

Introduction ................................................................................................................................ 3

Sensitivity analysis..................................................................................................................... 3

Scenario analysis ........................................................................................................................ 4

Break Even analysis ................................................................................................................... 4

Simulation analysis .................................................................................................................... 5

Recommendation ....................................................................................................................... 6

Conclusion ................................................................................................................................. 7

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Introduction

Capital budgeting is highly dependent on the cash flow process and the investment process. In
any organization along with the financial organization, budgeting is the most important factor
for maintaining the ratio between earnings and expenditure. The Most of the finance market is
highly related to the capital market as the investment market has a direct link with it. On the
other hand, for a healthy business scenario, the most important factor is proper viability. In this
case the process or practice of doing viability before making any long-term investment is
denoted as capital budgeting. This study will make discussion on the capital market and capital
budgeting. This discussion will also shed light on the different instruments of capital budgeting
which are essential for better viability. This study will also analyze the relation of sensitivity
analysis, scenario analysis, simulation analysis, and breakeven point Analysis in context to
different financial markets.

Sensitivity analysis

The capital market or the financial market is highly depended on the effect of different factors
on the investments in aiming to make risk free investment. In the capital market different
factors such as international and national political affairs, geographical factors, and engineering
factors and so on, might affect any investment. This factor generates sensitivity in the growth
rate on the capital market for which the graph is never constant and faces continuous ups and
downs. It is also known as the what-if analysis, the analysis is dependent on different factors,
and the changes in the graph depends on different conditions (Alonso et al. 2016). This process
in the capital market gives importance towards the NPV. In the capital market, the investment
is not always done in a lump sum or in a single place. The investment might be done in different
project for different payback terms. Hence, this inflow of the cash is highly dependent on the
return based on the invested amount. This is a comparison basis method where the profitability
is measured through the comparison between the net invested amount and the return amount.
Ion this process of valuation the investment token might be of different tenure (Faccio et al.
2016). In such case, the discounted return might vary with the interest rate and the tenure of
the return. However, the only condition is, it is assumed that all the investment is initiated from
the same date. It gives importance towards the time value as it can maximize the profit of the
investor. In this method, the investor also gives importance towards the expenses in order to
understand the net profit. If the net in cash stays higher than the invested amount then it is
considered as the risk-free investment. In a market scenario, Holiday Co Ltd decided to make

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investment ion the decoration as it can help in increasing the sale. In the previous year, an
investment of 20% helps the organization in increasing a sale of 500 units. Hence, the crowd
factor and attracting the crowd acted as the sensitivity factor to increase the sale. Hence, it
relies on the payback period where the earning is dependent on the investment and the profit is
gained after the payback period.

Scenario analysis

This gives importance towards future events that can leaved effect on the investments and the
financial market. This is defined as one of the best way if projection where projects the gives
importance towards the present scenario and the most possible scenario in the future. Whether
it can be inflation or natural events are the political factors (Joos et al. 2016). The analysis
considers how the factors are going to leave an effect on the investment. In several scenarios,
the analysis finds out the turning points and the way these points are going to leave an effect
on the capital market. Generally it relies on the payback method as the outcome is visible on
which the surrounding factors leave effect. The payback method is one of the successful
method, which gives importance towards the paying back of the investment amount. The
financial market that deals in lending money and generates the revenue from the interest
amount deal with the payback period. Hence, the payback period is dependent on three factors
such as economic life cycle, cash inflow and investment. In such a case, the project does not
consider the time value of money (Abor, 2017). This factor related to the capital budgeting
gives importance to the tenure and way the revenue will generate with time. This proper
understanding helps in understanding the risk factor in making any investment. Hence, the
result omits the time value of money and considers only profitability. Let an investment is done
on one lac for 4 years where the invested amount will get mature on that time. The investor has
received 28 thousand every years. Hence, the payback period is four years where the investor
gets the principle along with the interest. The sum of the received amount denotes that the
investor has gained profit from the investment also.

Break Even analysis

It is one of the most appreciated way to analyse the future market and identify the risk factors
before making any investment. It is graphical representation if a number of factors where the
profit and loss is been analyzed through the graphical representation. The analysis gibes

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importance in different cost factors to analyse the income and the net income. Hence, in every
project, there is always a fixed cost and variable cost (Kleinberg et al. 2018). On the other
hand, the direct and the indirect variable cost is also considered in aiming to make a proper
assessment of the risk and the market in aiming to make the right investment. On the point the
income crosses the cost factors is denoted as the breakpoint and the gap along with the Y-axis
is the measure of the profit based on all the cost. The breakeven analysis gives importance
towards the payback technique, which only measure the return and amount of profit. In the
payback, method there is still a drawback, in that case understanding the profitability for
multiple numbers of investments. Hence, the Accounting rate of return process gibes
importance towards the average method adhere average investment is taken into count to
analyse the risk factored through understanding he average income from the investment done.
For a particular investment or investment done in a project do not depend on the percentage
return from any specific investment (Caballero et al. 2017). Hence, any project having the
return rate higher that ARR might get the approval from the management to go with it,
otherwise the management might reject the investment plan. However, this method also gives
importance towards the compensation method, which indicates only the earning concept.
Besides that, it also does not gives importance towards the value of money concept. Hence, for
a specific project the share is been divided in a number of smallest token amount bad the object
is behind doing so is maximizing the share value.

Simulation analysis

This is the process, which is used in the present market scenario in aiming to identify the proper
risk factors and the market condition in the present and future, also which might affect the
investment market. In the simulation technique, the software is being used for simulating the
factors and identify the effect of the factors in the invested amounts along with the financial
market. In this scenario, the parameters are been analysed in terms of time and the variable
nature of the factors. It is denoted that the variable nature of the factors leaves the variable
effect on the capital market. However, it is not possible to gain an identical result where the
variable might leave a different effect based on time. The exogenous variable are compared
with in different ways as it acts as the decision-making factor (Arnold and Yildiz, 2015). The
factors are analysed multiple times and the result is varied for different analysis. Hence, the
average outcome is been simulated and used in aiming to make any decision in the capital

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market. The simulation is dependent on the IRR technique as the return rate is dependent on
the variables such as time and the return rate. It is one of the most profitable and the secure
way to make an investment in any case and maximize the earning. The capital market always
looks forward for a secure investment and the earning from the investment is highly dependent
on the return rate. In the process of IRR, the return is based on the investment amount and the
return rate is based on the principle amount where it is subject to time. In most of the processes,
the principle is not treated as the fixed amount in the time of return (Patrick and French, 2016).
On the other hand, with time, the participle amount decreases and hence the interesting part
decreases with the principal amount in aiming to reach the generalized interest rate. In this
scenario most of the organization design the payback amount or the cash inflow where the
interest part is been taken more ibn the initial stage which decreases the risk factor as after any
discount there will be more part of the profit and the received cash amount will be more than
the invested amount. This simulation technique is also highly dependent on probability settings.
In the random technique the factors are been analyzed in a proper way as it collects data in a
random way which helps in proper analysis to identify the future market and its effect on the
investments.

Recommendation

In capital budgeting, the most important factor is understanding the inflow of capital and
outflow of capital. On the other hand, the surveillance of any company is highly dependent on
the revenue generation along with the profit generation. Hence, it is essential to identify the
proper way to get the return in such a tactical policy that the investment becomes secure and
chances of failure is minimized. In the capital market, the most successful way to get the return
is the use of the IRR technique of return. In the process of IRR, the return is based on the
investment amount and the return rate is based on the principle amount where it is subject to
time. In most of the processes, the principle is not treated as the fixed amount in the time of
return. On the other hand, with time, the participle amount decreases and hence the interest part
decreases with the principal amount in aiming to reach the generalized interest rate. In that
case, the rate of failure is too low as in the interest part or the profit is been gained in the
primary stage. On the other hand, it is essential to identify the future and make the investment
based on future possibilities based on the market situation and the costs. It can be the most
efficient way to use the simulation technique, which will analyze every variable, and viewed
coast factors based on different conditions to get a generalized condition. The random
probability might help in identifying the factors that can leave a maximum effect on the earning.

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Conclusion

This study has highlighted the factors of the capital market, way of profit gained in a way to
minimize the risk factors to make the investment secure. This discussion has analyzed Capital
budgeting techniques such as Payback Period, Accounting Rate of Return, Discounted Payback
Period, Net Present Value, Internal Rate of Return and Profitability Index. On the other hand,
this analysis has also analyzed the risk assessment techniques such as sensitivity analysis,
Scenario analysis, Break Even Analysis, Simulation analysis. In the capital market different
factors such as international and national political affairs, geographical factors, and engineering
factors and so on, might affect any investment. On the other hand, the direct and the indirect
variable cost is also considered in aiming to make a proper assessment of the risk and the
market in aiming to make the right investment. In the simulation technique, the software is
being used for simulating the factors and identify the effect of the factors in the invested
amounts along with the financial market. It is observed that the capital market gives importance
trio wards the IRR technique in case of gaining the return and the salutation technique is used
as the most liable technique to determine the future.

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