Investment Decisions Implications Capital Budgeting

Question: Discuss about the Investment Decisions Implications for Capital Budgeting. Answer: Introduction Sensitive analysis and scenario analysis both are performed for decision making regarding the investments. In a sensitivity analysis, many factors which influence decision is tested for seeing their sensitivity in decision making. Capital budgeting techniques are also used for investment decisions. Scenario analysis related to budgeting regarding the future cash inflow and outflow. This report is going to put light on the way in which sensitive analysis and scenario analysis used in capital budgeting technique. The capital asset pricing model is a most celebrated model of finance for asset pricing. This model has some assumptions and some theories which will be discussed in this report. The capital market line is also derived from capital asset pricing model. This line indicates the extra return by including risky stocks in the portfolio. This report puts light on both capital market line and capital asset pricing model. What is capital budgeting Capital budgeting is a technique which helps in decision making regarding the investment decisions. In capital budgeting, one estimates regarding the investment and revenue from any project (Myers, 1512). Sensitivity analysis in capital budgeting Sensitivity analysis gives some addition regarding the business decision using capital budgeting. There are many things which effect the decision making regarding any project like outflow involved in that project, duration for which project exist, inflow from the project and rate of expected return from the project etc (Chan, Saltelli, and Tarantola, 2000). Which factor is most sensitive for the project is measured by this analysis. The most sensitive factor can affect the investing decisions at most hence; this factor is required to be focused. This focuse is also required for ensuring that the most sensitive factor will fluctuate within the tolerable range, so that project must be profitable. Moreover, in this analysis two approaches are used by the decision makers one is the shock approach and another one is the margin of safety approach (Lenhart et al., 2002). In the shock approach each risk factor shocked at unfavorable direction at a specified percentage then percentage fall in net present value is estimated. For which risk factor percentage fall, in net present value is the highest will termed as a most sensitive risk factor. In the margin of safety approach, the net present value set as zero, and break-even value of each risk factor is calculated. Risk factor, whose margin of safety becomes lowest will term as a most sensitive risk factor. Additionally, this approach is having an assumption that all factors are independent (Helton et al., 2006). However in real world factors can be independent and can be not independent in some cases, like fixed cost and quantity are independent factors but price and quantity factor cannot be independent of each other. Scenario analysis in capital budgeting Scenario analysis is performed for evaluating outcomes of any internal and external phenomena on the project, like inflation is external phenomena but it effects the project investment decision, hence this analysis measures the effect of inflation on the profitability of the project. Scenario analysis shows the probable future of a project that can be different for reality hence it should not assumes an as accurate picture of future (Boundless, 2016). Most of the scenario analysis consists three scenarios first is the base case which is a most likely picture of future, second is the worst case it is the outcome from the pessimistic approach, and the last one is the best case it is the outcome of optimistic approach. In the scenario, analysis budgets play a most important role because scenario can only be seen by the budgets. In scenario analysis, through the help of budgets, one can make capital budgeting decisions like, where to invest, duration of investment, the amount of spending etc (Postma and Liebl, 2005). It is always recommended by the advisers that before any investment one should read every outcome from that investment. It can be concluded from this paragraph that scenario analysis is making a budget of future investment any make a study regarding each aspect of that investment. Moreover, there are so many advantages of scenario analysis. First one is it helps in escaping from non-profitable investments. This analysis helps in assessing the future situation of the project, which indicates all circumstances regarding the investment. It minimizes the risk factor through all projections regarding the future of the upcoming project (Clemons, 1995). It also forecasts regarding the return of investments. Additionally, scenario analysis is the result of many sensitivity analyses, the budget required for scenario analysis can derive only after performing sensitivity analysis. For making the budget as tends to the future one should know regarding the sensitivity of each factor and change in profitability on any change in specified factor and this information are the conclusion of sensitivity analysis. Capital asset pricing model The capital asset pricing model is a most used model in financial decision making. As per this model price of any asset is the present value of future cash flow which is discounted at a rate which is the addition of return from risk-free investments and risk premium. This model risk is an only systematic risk; this model does not consider unsystematic risk. As per this model, Expected return= Risk free return + (Return from market portfolio - Risk free return) * Beta of stock This model has some assumptions like, investors are rational, the market is perfectly competitive, all investors having homogenous expectations, there is the unlimited opportunity for selling and purchasing risk-free stocks and market is in equilibrium (Merton, 1973). Capital asset pricing model gives a concept of security market line; this line is derived from the capital asset pricing model. In security market line beta represents x-axis and expected return represented by y-axis. All truly priced stock lies on security market line. Capital Market line The capital market line is the extension of capital asset pricing theory, capital market line shows the additional return more over risk-free rate of return from a change in risk level. This line starts from the point where risk is zero i.e. return from risk-free stock and standard deviation represents x-axis and expected return represented by y-axis. This line shows the increase in risk and return by increasing risky stocks in the portfolio and compromising risk-free stocks from the portfolio (Sharpe, 1964) and provides a theoretical efficient market portfolio from which efficient frontier is drowned. This analysis helps the investors in investing decisions for achieving expected return for fair risk amount. The concept of capital allocation line also includes one more concept i.e. separation theorem, it is the process of allocating funds between risky and non-risky portfolios. Similarities between Capital asset pricing model and Capital Market line Capital asset pricing model and capital market line both models are used as the measure of risk and return. These both concepts establish a direct relationship between risk and return. Both models are used for making investing decision regarding the securities. In both model risk-free stocks play a significant role. Both models are used for calculating the market return. Differences between Capital asset pricing model and Capital Market line As per capital asset pricing model, there is an only systematic risk because this model assumes the investor is investing in market portfolio i.e. a most diversified portfolio of the market hence unsystematic risk of each stock canceled off. Capital market line considers both types of risk. Hence Capital market line uses sigma i.e. standard deviation as a measure of risk on the other hand capital asset pricing model uses beta as a measure of risk. Additionally, capital asset pricing model gives the estimate regarding the risk and return of the stock on the other hand capital market line gives the estimate regarding the risk and return of from the portfolio. Hence, capital asset pricing model used in decision making when an investor wants to invest in signal stock on the other hand capital market lines concept used by the investor when he is going to invest in the market portfolio. Moreover, capital asset pricing model gives the graph representation in way of security market line and capital market line gives its representation in for of capital market line itself. The capital market line is a representation of portfolio, on the other hand, security market line is a representation of a stock only. Furthermore, capital asset pricing model only considers market stocks but capital market line considers all risky and nonrisky assets. Although there are so many differences and similarity between two concepts but still, these are interconnected concepts of finance which help in security markets investing decision making. These models are one of most used models in the finance world. Conclusion This report concludes that in capital budgeting decision both scenario analysis and sensitivity analysis plays an important role, for appropriate results from capital budgeting one must perform these analysis. Through the use of many empirical supports, this report provides facts regarding the theories of capital asset pricing model and capital market line and similarities and differences in between these concepts. These concepts are used in decision making for investment in the security market. References Myers, S.C. (1512) Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk,The Journal of Finance, 29(1), pp. 125. doi: 10.1111/j.1540-6261.1974.tb00021.x. Chan, K., Saltelli, A. and Tarantola, S. (2000)Statistics and Computing, 10(3), pp. 187196. doi: 10.1023/a:1008950625967. Lenhart, T., Eckhardt, K., Fohrer, N. and Frede, H.. (2002) Comparison of two different approaches of sensitivity analysis,Physics and Chemistry of the Earth, Parts A/B/C, 27(9-10), pp. 645654. doi: 10.1016/s1474-7065(02)00049-9. Boundless (2016)Scenario analysis. Available at: https://www.boundless.com/finance/textbooks/boundless-finance-textbook/the-role-of-risk-in-capital-budgeting-12/scenario-and-simulation-assessments-99/scenario-analysis-427-7232/ (Accessed: 21 January 2017). Helton, J.C., Johnson, J.D., Sallaberry, C.J. and Storlie, C.B. (2006) Survey of sampling-based methods for uncertainty and sensitivity analysis,Reliability Engineering System Safety, 91(10-11), pp. 11751209. doi: 10.1016/j.ress.2005.11.017. Postma, T.J.B.M. and Liebl, F. (2005) How to improve scenario analysis as a strategic management tool?,Technological Forecasting and Social Change, 72(2), pp. 161173. doi: 10.1016/j.techfore.2003.11.005. Clemons, E.K. (1995) Using scenario analysis to manage the strategic risks of reengineering,Long Range Planning, 28(6), p. 123. doi: 10.1016/0024-6301(95)99966-4. Merton, R.C. (1973) An Intertemporal capital asset pricing model,Econometrica, 41(5), p. 867. doi: 10.2307/1913811. Sharpe, W.F. (1964) CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*,The Journal of Finance, 19(3), pp. 425442. doi: 10.1111/j.1540-6261.1964.tb02865.x. Sharpe, W.F., Alexander, G.J. and Bailey, J.V., 1999.Investments(Vol. 6). Upper Saddle River, NJ: Prentice-Hall.