Financial intelligence for HR Professionals-Samples for Students

Question: How Management decision making could be related to Capital Budgeting Techniques such as, internal rate of return, net present value etc. Answer: An organization is based on the decisions made by its management. Therefore, decision making process turns out to be a crucial part of an entity as one wrong decision could result in heavy losses to the firm whether in terms of revenue or reputation. 'Decision - making involves the examination of various courses of actions and choosing the most appropriate option in order to arrive at a conclusion for a given scenario. Decision making process focuses on' goals'. It is continuous in nature as our business environment is dynamic so as soon as one problem ends, the other one arises and it goes on (Berman, Knight and Case, n.d.). Corporate decision making takes place at various levels of the entity whether top down or bottom up. Corporate decision making is characterized by its implementers because a decision is effective only when it is being implemented in the best possible manner. The large laid plans can go in vain if there is no commitment from the middle lower management. Hence, it is important for a management to maintain a good healthy relation with its middle level lower level management (Bruner, Eades and Schill, 2017). Thus, corporate decisions are successful as long as there is a 'glue' to keep the organization together in the form of encouraged leaders and the firm that values coherence maintains stability otherwise the entity falls into its own trap leading to loss of competitiveness in the market. Capital budgeting refers to the evaluation of the huge amount of expenditures and investments. These expenses or investments include projects such as building a new plant or long term investments (TULSIAN, 2016). Through capital budgeting, it becomes easier to evaluate whether the returns provided by the company are meeting up with the targets, this is done by calculating the lifetime outflows and inflows. This canalso be named as investment appraisal. For a business, it is advantageous for it to take up all opportunities and projects but due a Limitation of the availability of capital at a particular point of time, management uses capital budgeting techniques to determine the maximum return from all the available projects at a time (Clarke and Clarke, 1990). There are huge number of methods involved under capital budgeting, they are explained below: DCF Analysis: The NPV concept and the DCF concept is similar to each other. In both the case the initial cost, maintenance cost and the other cash outflows and inflows are pulled back in order to compute the Net present value of the project. NPV: The amount of cash inflows over the cash outflows is known as Net present value. It is used in the process of decision making through capital budgeting to determine the profitability from a project or a long term investment. The positive NPV of a project is an indication that the projected earnings exceed the costs while a negative NPV results in a loss (Fairhurst, 2015). For example- There are two projects A and B having different structures of cash flow and the required rate of return is 10.25 percent then the NPV of the cash flows will be as follows: Calculation of Net Present Values of each project NPV of Project A Year Cash Flow Present Value of Cash Flows 0 -50,000 -50,000 1 17,000 15,420 2 17,000 13,986 3 17,000 12,686 4 17,000 11,506 5 17,000 10,437 NPV 14,034 NPV of Project B Year Cash Flow Present Value of Cash Flows 0 -50,000 -50,000 1 - - 2 - - 3 - - 4 - - 5 99,500 61,084 NPV 11,084 Discounted Payback Period: This is a capital budgeting technique that determines the period required to break even from undertaking an initial expenditure by pulling the future value to the present value on practising time value of money. The rule says that the projects with discounted payback period less than the targeted period are to be accepted. IRR : IRR is defined as the interest rate at which the NPV of all the cash flows id zero in a given project or investment. This is used to evaluate the attractiveness of an investment. The rule says that the project is acceptable if the required return of the investor is less when compared to the IRR. However if the required rate is more than IRR then the project is not acceptable by the investor (Taylor, 2008). From the same example that has been taken for NPV we are calculating IRR: Calculation of Internal Rate of Return of each project For Project A: For Calculation of IRR, Inflow=Outflow Let be IRR 20.70% then PV of Inflows Year Cash Flow Present Value of Cash Flows 1 17000 14,085 2 17000 11,669 3 17000 9,668 4 17000 8,010 5 17000 6,636 50,067 Therefore, at 20.70% Pv of Inflows = PV of Outflows (50,000). Hence IRR is 20.70% For Project B: For Calculation of IRR, Inflow=Outflow Let be IRR 14.70% then PV of Inflows Year Cash Flow Present Value of Cash Flows 1 - - 2 - - 3 - - 4 - - 5 99500 50,119 NPV 50,119 Therefore, at 14.70% Pv of Inflows = PV of Outflows (50,000). Hence IRR is 14.70% Importance of Capital budgeting techniques is: Evaluation of Risks: long term investments are capital expenditures that involves identifiable and significant financial risks. Therefore, for proper planning, capital budgeting is important (Galbraith, Downey and Kates, 2002). Choosing of the best course of action: It helps a company to choose the best investment project that would give the best possible returns after considering every possible course of action available. It focuses on increasing the shareholders wealth and helps a company in achieving an edge in the market. Irreversible Investments: the funds are limited but involve huge investments. Therefore it is better to analyze the every possible scenario before investment as once a decision is being taken or once the money is being invested; there is no option of reversing back the decision. Long run of the business: capital budgeting helps in reduction of costs as well as determination of best maximum profit of the company. Since it helps in avoiding the over or under investments, proper planning analysis through capital budgeting helps in sustainability of the business in the ling run (Shim and Siegel, 2008). Various capital budgeting techniques includes: Sensitivity Analysis: This is an analysis of determining the result of a decision using different range of variables. The analyst determines the changes in dependent variables due to different values of independent variables assuming certain conditions to be constant. Its other name is what if analysis. Analysis could be made for any type of decisions be it a family vacation or corporate level decisions. Its basic meaning is determining the sensitivity in output because of variation in a particular ouput keeping the other constant. (Hassani, 2016). Following are the steps for conducting sensitivity analysis : The base case output is defined; say NPV at a particular base case input value (V1) for which the sensitivity is to be measured keeping all other inputs constant. The value of output is being determined at a new value of input (say V2) keeping other inputs same. Then, the % change in output the % change in the input is identified. The method to calculate sensitivity is dividing the percentage change in output by percentage change in input. The conclusion is being arrived with the fact that higher the sensitivity figure is, the more sensitive the output is to any change in that respective input and vice-versa. Scenerio Analysis : This is a process of determining the 'expected value' of an investment after a given period of time assuming certain differenced found in the values of key factors such as interest rates,etc. As a technique, this analysis requires an analyst to compute different reinvestment rates for expected returns that are invested again again and again during a particular time period. This analysis basically determines the changes in the values of the portfolio based on happening of different scenarios and follows the principles of 'what if' analysis. This evaluation is used to determine the risk present within a given amount of investment as related to a variety of potential events, ranging from highest to lowest probabilities. An investor through this analysis determines the level of risk that can be undertaken. There are various approaches of it including the most common approach called standard deviation of daily ot monthly security returns and then computing the expected value of the portfolio if each security generates returns that are either two or three standard deviations above or below the average returns (Holland and Torregrosa, 2008). Through this way, an analyst determines the reasonable certainty regarding the changes in the portfolio's values at a particular time period. It is important to note here that the above two analysis are not the same. This can be better understood with an example. For example, an equity analyst wants to conduct both sensitivity scenario analysis to consider the effect of earnings per share (EPS) on the company's relative valuation by using price to earnings (P/E) multiple. The sensitivity analysis depends on the variables affecting valuation, which can be depicted using variables' price and EPS. Through this analysis, the range of all possible outcomes are being recorded. While on the other hand, scenario analysis is being done by determining the outcomes based on a scenario. The analyst has to determine a certain scenario such as market crash or changes in regulations of the industry. He then uses different variables within that model to suit that scenario. If all these factors are being put together, the analyst has a broad picture including all range of outcomes, given all extremes, and an understanding of different outcomes using different set of inputs characterized by real life scenarios (Khan and Jain, 2014). Break Even Analysis : a point where the company is generating enough revenue so as to cover all the expenses incurred during that accounting period is known as breakeven point. By definition, the company's net income would br zero, that is, no profit no loss (Saunders and Cornett, 2017). It is important to state that the company's payback period isn't used to find the breakeven point as payback period is concerned with the number of periods needed to pay back an initial investment, while the breakeven point is concerned with the equalling of revenue and total costs with zero net income. This analysis shows that how many sales it takes to pay off the costs of doing that business. Following two points are to be considered : Accounting breakeven analysis : An accounting breakeven happens with total revenue equalling total costs,that is, profit is zero. This can be reached by computing the ratio of variable cost to sales. For example, the ratio is 0.65 so this means that with every rupee of a sales of each unit, contribution is.0.35 (Palepu, Healy and Peek, 2016). Thus, the contribution margin ratio becomes 0.35. Breakeven point can therefore be calculated as : BEP = (Fixed Cost + Depreciation) /Contribution Margin Ratio. If we do not add the depreciation, the same BEP is called as cash break even point. The project that reaches the breakeven point indicates that there are zero returns. Thus, only the investment value will be recovered. Financial breakeven analysis : An NPV breakeven occurs when the cash flows are equivalent to the initial investments, that is, the NPV is zero. Thus, to arrive at breakeven point, an analyst makes an analysis of reaching that level of sales where the NPV of the project is zero. Simulation Analysis : The term 'simulation' means an imitation of something or pretending of some action. Monte Carlo Simulation is an analysis of imitation of some real things or star of affairs or different processes that represents the key features of a system using random numbers (Phillips, 2014). It basically adds the dimensions of uncertain and moving analysis to capital budgeting as it involves building up of various scenarios which are in accordance with the assumptions of the analyst. It considers the interactions the probabilities of changes in variables. This analysis involves following steps : The variables are to be identified that influence both cash inflows outflows. The formula is to be stated relating all the variables and then, a probability distribution for each variable is to be determined. Now, a computer programme is to be developed that randomly selects one value from the probability distribution of each every variable and determines the project's NPV using such values. The outcome in this regard is not a single value result but a probability distribution of all the possible expected returns. Simulation analysis is a significant tool to understand from the depth of the capital budgeting so as ti enhance the investment decisions (Reilly and Brown, 2012). However, it is unable to deal with the uncertainties. Also, such an analysis is not a remedy of all problems as overlooking of important inter relationships between the variables can lead to wrong conclusions and misleading outcomes. Capital Budgeting techniques are important for corporate decision making but it has certain limitation too. Some if them are listed below : Since it has long term perspective therefore it cannot be used for short term implications. Also, decisions taken on the basis of capital budgeting, if in case, turns out to be wrong, can adversely affect the long term survival of the business. Also, it leads to increment in operating expenses (Saltelli, Chan and Scott, 2008) . Inadequate wrong investments makes it difficult for the business to make a proper budget and the capital. Such decisions includes large amount of funds and therefore, decisions are to br made very carefully as once the decisions are taken, it cannot be modified. References: Berman, K., Knight, J. and Case, J. 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