Capital budgeting techniques: Sensitivity and Scenario analysis

great(p) budgeting techniques sensitiveness and Scenario synopsisGraphic solelyy show and explain the undermenti unityd terms, how you could link them to metropolis budgeting techniques in your finale making (1000 words)Sensitivity depth psychologyScenario psychoanalysisSensitivity epitomeSensitivity analysis is a what if ray of light that examines the effect of increase or decrease in a lodges net profit. Sensitivity analysis bay window help in answering question like What would be the forecasted net income if sales be increased or decreased by 30%, 20% or 10%.Sensitivity analysis is frequently used in with child(p) budgeting for determining how sensitive an NPV analysis is to changes in inconsistent assumptions. While conducting analysis, to each one variable is fixed except one and by changing this one variable, the effect on NPV or IRR tramp be viewed.The first clapperclaw in performing a sensitivity analysis is building a base character reference scenario. This is typically the NPV using assumptions which are believed to be accu pasture. From this manoeuvre various assumptions can be changed which had initially been based on possible assumptions. NPV is then recalculated and the sensitivity of NPV based on the change in assumptions is determined.Scenario summaryScenario analysis is a process of analysing decisions by considering alternative possible outcomes. Scenario analysis is designed to see the consequences of an action under different set of factors.Scenario analysis takes sensitivity analysis a step further. Rather than just facial expression at the sensitivity of the NPV analysis to changes in the variable assumptions, scenario analysis withal looks at the probability distribution of the variables.Like sensitivity analysis, scenario analysis starts with the gimmick of a base case scenario. From there other scenarios are considered know as the best case and worst case scenario. Probabilities are charge to the scenarios and co mputed to arrive at an prize value.Capital Budgeting and Use of Sensitivity and Scenario AnalysisCapital budgeting is the process of analysing a companys enthronization decisions such(prenominal) as investing in new equipment, machineries, plants, projects and products. This process involves the estimation of the pass judgment cash flows, the calculation of the Net Present Value (NPV) and the calculation of the indispensable Rate of Return (IRR) of the investment. NPV is defined as the present value of all cash inflows minus the present value of all cash outflows. If NPV is positive, the investment is making money and is thus viable. IRR is defined as the deductive reasoning rate that makes the NPV zero. If IRR is greater than the opportunity cost of capital then the investment is feasible. on that point are two obstacles involved in the capital budgeting process. One involves the catch up with estimation of expected cash flow. The other is the use of correct discount rate a lso known as the project cost of capital.Capital budgeting is by definition, forward looking. When dealing with expected resources and demands, uncertainty is a major factor. Sensitivity analysis is a statistical tool that determines how consequential deviations from the expected value occur.Capital Budgeting exampleXYZ Water Filtration Plant removes to throw a new peeing filtration plant to filter 20 zillion litre water and deliver to consumers. An assessment should be carried out to evaluate the economics of the project and determine which parameter is sensitive to investment value, also to establish a sales price. Market price of water is $4 $5 per litre therefore, four different water price scenarios would need to be analysed to reach the best economic parameter, they are $4, $4.25, $4.5 and $4.75.The selection criteria would be based onNPVCost of Capital 15%IRRAnalysis and equality of AlternativesPreliminary data and estimationTable 1 Project readingTable 2 service lin e Cash flow calculationBaseline cash flow and NPV are calculated as followsTable 3 Sensitivity Analysis CalculationIn sensitivity analysis, each variable is changed one at a time to analyse its impact on the end result. In this case the impact of 10% increase or decrease in receipts, capital investment and operational cost is considered on the NPV.From table 3, a sensitivity graph can be plan as followsBased on above sensitivity analysis, it is evident that the revenue by terms of price is the main variable that is affecting NPV. so the economic optimization and evaluation will be based on parameter water price. Using formula in the spreadsheet, following can be obtainedTable 4 Water Sales Price Scenario endurance of preferred alternativeFrom table 4, we can conclude that best scenario is at water price $4.74 per litre, refer to criteria NPV, IRR and Payout Time. Then the project is worth doing, with the water price $4.75 per litre resulting NPV0, IRRMARR and payout time less tha n five years.Benefits of using Sensitivity AnalysisSensitivity and scenario analysis in useful in capital budgeting techniques for a number of reasons, includingIt supports decision making or the development of recommendations for decision makers such as testing the robustness of a result.Financial forge makers can effectively communicate with the decision makers for example, by making recommendations more(prenominal) credible, understandable and compelling.Increases understanding of relationships between input and output variables.It helps the investor to maintain their pretend comfort level. Once projections are made concerning a specific investment, it can be decided whether risk should be taken for the worst case scenario.SOURCE http//businessplanhut.com/what-sensitivity-analysis-example-and-components-involved Source Boundless. Scenario Analysis. Boundless Finance. Boundless, 03 Jul. 2014. Retrieved 27 Apr. 2015 from https//www.boundless.com/finance/textbooks/boundless-finan ce-textbook/the-role-of-risk-in-capital-budgeting-12/scenario-and-simulation-assessments-99/scenario-analysis-427-7232/ http//www.assakkaf.com/courses/ence 627/lectures/chapter5.pdf http//www.spreadsheetml.com/finance/capitalbudgeting.shtml http//www.slideshare.net/ranasingh0820/sensitivity-amp-scenario-analysis https//kristal2011aace.wordpress.com/2011/09/22/w2_adi_the-gas-plant/comments