Capital Budgeting Technique as a Decision Making Tool - Click Now

Question: Discuss about the Capital Budgeting Decision Making. Answer: Introduction Capital budgeting is a technique used for a business, which helps the corporation in the amount that to be invested in a portfolio. It is a methodology used by the corporate managers for better understanding of risk and return analysis of portfolio. This technique is used by managers for better investment of long term assets, as they are the only one which generate more cash value to the company in a long run. It is considered as a challenging task as it consists of investment decision and majorly funds of the company are blocked in the portfolio (Kersyte, 2012). Hence it has to be ensured by the management that the selected portfolio will generate cash flow in a long run. It provides a better focus on the company goals and objectives. However there are various methods which are used in capital budgeting that are internal rate of return (IRR), net present value (NPV), profitability index (PI), accounting rate of return, modified internal rate of return (MIRR), average accounting rate of return (ARR), payback period. All these methods are used in capital budgeting analysis, to make a match between actual results and expected results (Karanovic, Baresa Bogdan, 2010). To conduct risk analysis, capital budgeting lays some techniques which are hillers model, break even analysis, sensitivity analysis, simulation analysis, scenario analysis, and decision tree analysis. Following are some of the methods discussed. Sensitivity analysis It is the study which tells about that how much the level of uncertainty in the output can be distributed over the different inputs of the portfolio. It is also called as what if analysis. It is a technique used to define the extent to which the predicted performance is affected by the uncertainty in the assumptions of the portfolio. This analysis is called as what if analysis because it is used for comparative analysis in various projects and their risk and return analysis. There are two major benefits of sensitivity analysis. The first benefit is for the investor that is he/she would get a better vision that which project is more sensitive to the uncertainties. Hence it would be easier for him/her to conduct a comparative analysis and invest in a best portfolio matching with his goals. The second benefit to the investor is that his/her views would be clearer as to rely upon NPV decision or not. As sometimes NPV gives vague answers. However there are some critics also. The first critic is that only one estimate is taken at a time in sensitivity analysis. That is simultaneous changes of the factors are not considered. The second critic is that, no indication is given to the investor that how sensitive analysis should be done, that is its uses and its evaluation. In sensitive analysis each variable is treated as separate, it is when the different variables are related to each other. It can be better understood that if in a company variable costs, fixed costs, and investment costs are raised above the expectation simultaneously. In this case sensitivity analysis will only take one variable at a time. Hence by this it can be arrived at a solution that this analysis is done for better understanding of the effect of exogenous variables that is independent variables over endogenous variables that is dependent variables. Relationship between sensitivity analysis and capital budgeting Capital budgeting helps a corporation in deciding the amount that to be invested in a project and the desired returns for the respective project. Sensitivity analysis guides that one input variable can be changed at a time, and its effect on the output variables. It guides the management and investors that which project is a better return giving project (Hall Millard, 2010). As per Colin Drury, analysis in NPV is done on variables like investment costs, initial outlay, and its components like selling price, selling units, sales volume, interest rates and discount rates. The net present value method has various assumptions so to calculate about underlying sensitivity of a project, and the extent of that sensitivity. According to him sensitive analysis is done to calculate about sensitivity and responsiveness of net present value to the different uncertainties (Zhamoida, Matsiuk, 2011). Scenario analysis It is a technique which is adopted by corporate managers to get to know about that how the project outcomes will change under already known circumstances. In this analysis an expected value is determined for a given period of time. The expected value of the financial analysis results changes because of changes like time value of money, interest rates. When NPV is computed of different projects by an investor, it is considered as scenario analysis. As because of uncertainty, sometimes the financial result outcome may be completely unexpected even though there has been NPV analysis of different projects laid down (Kengatharan, 2016). To select the best portfolio both sensitive analysis and scenario analysis is done. The amount and the extent of uncertainty are answered by sensitive analysis. In sensitive analysis the outcome effectiveness is considered by keeping in mind certain variables. While in scenario analysis which financial result is most likely to happen is analyzed. In scenario analysis a number of variables which can be homogenous are considered, and how they influence the factors of financial results outcomes. In complex situation scenario analysis is suggested. According to this there can be two market condition weak market condition and strong market condition. In weak market condition, it is expected by the investor that unit sales would be less, and hence the unit cost would be also be less. While in case of strong market condition it is expected by the investor as sales would be increase and that would lead to increase in unit costs (Lunkes, Feliu, Fillil, Rosa, 2015). Relationship between scenario analysis and capital budgeting Scenario analysis provides a methodology in which evaluation of the variability is done in capital budgeting for example NPV. In this, base case scenarios are determined which are the estimated cash flows. According to base case scenario there can be two market conditions that are best market condition and worst market condition. NPV is determined under each market condition. This would enable the investor in getting an idea that in which NPV of the project would lie (Ryan Ryan, 2002). Capital asset pricing model (CAPM) In this model the expected return of equities are calculated in relation to a particular firm. Risk and return analysis are one of the most important factors to be considered before investing in any project or portfolio. It is usually said that the more return can be achieved if it is combined with more risk (Sharifzadeh, 2010). Hence it can be said that there is a positive relation between return and risk. But this differs as the investors perspective changes. Like in case of risk takers they like to bear more risk in return of getting more returns, while the risk avoiders avoid to take risk, as they want a fixed return on the project. Usually risk avoiders are the old man, or pensioners who want fixed return as to save money (Armitage, 2005). CAPM model is used by the investors and financiers so as to calculate the return to be required as to cover risk. However CAPM models lay some assumptions which are as follows: Unlimited funds can be borrowed by the investor that is there is no limit to the borrowing. However funds can be lent further at a risk free rate or zero rate of risk. Investors are assumed to be wealth maximizes that is an investor would select a portfolio based on the expected return and standard deviation. All the financial assets are fully divisible. All the investor lays homogeneous expectations regarding the same portfolio. No taxation charges are levied Transaction cost is not levied. Investors cannot influence the market prices. The financial assets quantities are given and are fixed. All the findings or information related are provided to the investor, however this practice cannot be adopted universally as some information are being hidden to maintain confidentiality. CAPM equation Here: Rf= risk free rate that is zero risk rate =beta coefficient Re= equity return E(Rm)= it is market premium, also called as expected return of market rate (Vijendra, 2016). However two elements are included in CAPM model, those are CML which is capital market line and SML which is security market line (Elton, Gruber, Brown Goetzmann, 2010). CML (capital market line) Information regarding CML was provided in doctoral dissertation of Harry Markowitz in 1950s. According to him a CML is a graph which is derived from CAPM model. If a line is drawn as tangent line, from the point of risk free assets to a feasible region of risky assets, it is called as CML. CML is used to determine the rate of return required for a given portfolio. The analysis of CML depends upon the rate of return and the risk rate involved in a particular portfolio. In CML the relationship between return and risk is defined, so that a portfolio can be managed effectively and risk to be matched with the return (Brigham Daves, 2014). In a market portfolio whenever the risk free assets are combined, they provides a higher return. The basic objective behind CML concept was to combine risk free assets and market portfolio. This model is highly preferred by the experts as risk free assets are considered in the portfolio. However Harry Markowitz in 1952s mentioned that the basic aim of an investor for a portfolio is to make a balance between securities so that greatest return could be achieved with an acceptable rate of risk. Here the concept comes of efficient frontier where the optimal portfolio lies. However in CML the relationship between risk and return of individual securities are not specified, as it would be calculated by SML. Here only those portfolios are considered in which risk cannot be diverted. However SML is used if there is any risk return relationship SML is suggested. In CML, risk investments are not used, as only efficient portfolios are considered. In SML there are two types of risk those are systematic risk and unsystematic risk. Systematic risk can be said in a portfolio if the risk contained in it cannot be diversified by diversification like political and legal factors. While in a portfolio unsystematic risk can be said, if the risk can be avoided by diversification (Brigham Ehrhardt, 2013). CML equation E(Rp) = xE(Ry)+(1-x)Rf Here: x= the percentage of risky assets which are invested in a portfolio (1-x)= the percentage of risk free assets which are invested in a portfolio E(Ry)= risk assets portfolios expected return Rf= risk free interest rate (Jones, 2016). Similarities in CAPM and CML The equilibrium relationship is established between portfolio co variances and its expected rate of return, called as security market line which is called as CAPM. There is a positive relationship between CAPM and CML, which is as the risk increases, the expectation of getting return would also increase. However both CAPM and CML are used in determining the portfolio, hence it can be said as a good tool for portfolio management and investment analysis (Giovanis, 2007). Difference in CML and CAPM CML does not only depict the efficient frontier, but also depicts the relationship of equilibrium between and expected rate of return E(r) in all the efficient portfolios. In CML only efficient portfolio are considered, whereas in CAPM both efficient and non efficient portfolios are considered. In CML standard deviation is calculated to measure the risk, while in CAPM beta coefficient is calculated to measure the risk which is also called as the measurement of systematic risk. CAPM is not considered as realistic because it assumes that a portfolio would be selected by an investor on the basis of risk and return analysis (Kurschner, 2008). Conclusion Capital budgeting is a considerable decision to be taken by the corporate managers in an organization. As the decision to be taken in capital budgeting would affect the other decisions too in a corporate like financing decision. Hence it is suggested that for getting a better return on the investment, an analysis of portfolio management need to be done on regular basis. Hence for effective management, other level managers should be included. It needs to be questioned by the managers before investing in a security about the criteria of the decision, information to be required, decision and execution burden. References Armitage,S. (2005) The cost of capital: Intermediate theory, Cambridge university press, United Kingdom Brigham,E,F Daves,P,R.(2014) Intermediate financial management, Cengage learning, United States Brigham,E,F Ehrhardt,M,C. (2013) Financial management: Theory practice, Cengage learning, United States Elton,E,J. Gruber,M,J. Brown,S,J Goetzmann,W,N.(2010) Modern portfolio theory and investment analysis, John wiley sons, Hoboken Giovanis,E. (2007) Application of capital asset pricing (CAPM) and arbitrage pricing theory (APT) models in Athens exchange stock market, GRIN ,Germany Hall,J Millard,S. (2010) Capital budgeting practices used by selected listed south Africans firms, SAJEMS NS 13, No1. Retrieved at https://www.scielo.org.za/pdf/sajems/v13n1/07.pdf Jones,C,P.(2016) Investments, Binder ready version: Analysis and management, John Wiley sons, Hoboken Karanovic,G. Baresa,S Bogdan,S. (2010) techniques for managing projects risk in capital budgeting process. UTMS journal of economics, Vol 1, No.2 Kengatharan,L.(2016) Capital budgeting theory and practice: A review and agenda for future research, Applied economics and finance, vol 3rd, No.2nd Kersyte,A. (2012) Investment risk analysis: theoretical aspects. Economics and management. Retrieved at https://www.eis.ktu.lt/index.php/Ekv/article/viewFile/2099/1628 Kurschner,M. (2008) Limitations of the capital asset pricing model, GRIN, Germany Lunkes,R,J. Feliu,V,R. Fillil,A,G Rosa,F,S,D.(2015) Capital budgeting practices: A comparative study between a port company in Brazil and in Spain, Journal of public administration and policy research, Vol 7(3) Ryan,P,A Ryan, G,P. (2002) Capital budgeting practices of the fortune 1000: how have things changed?, Journal of business and management, Vol 8th, No 4th Sharifzadeh,M.(2010) An empirical and theoretical analysis of capital asset pricing model, Universal publishers, USA Vijendra,S. (2016) Comparative study of stock movement between Tech Mahindra and Infosys, Journal of advances in business management, volume 2nd, issue 1st Zhamoida, O, A, .Matsiuk, M, S,. (2011). Sensitivity Analysis in Capital Budgeting. 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