Corporate Finance Budgeting and Planning

Questions: 1. How their decision making could be related to capital budgeting techniques such as, Internal Rate of Return, Net Present Value etc. Explain the following concepts in relation to Capital Budgeting Techniques? 2. Explain and identify similarities and differences between Capital Asset Pricing Model and Capital Market Line? Answers: Introduction Capital Budgeting indicates towards the process that can be used for making business decisions regarding investments in different assets of long term of the corporation. The general conception is that the capital or the funds raised by a corporation can be utilized in the future for investment in different assets that can enable the corporation to generate revenues in the upcoming period. Every so often, these funds are not substantially available and the management of the firms need to make budgets and decide the way these funds can be invested. The current paper throws light on evaluation of decision making process using different techniques of capital budgeting such as the net present value (NPV) and internal rate of return (IRR) among many others. The current study also explicates in detail different concepts related to capital budgeting tactics such as the sensitivity analysis as well as scenario analysis. Moving further, the present segment also elucidates illustratively the Capital Asset Pricing Model and Capital Market Line along with the similarities and variances between the two. 1. Evaluation of the decision making process related to capital budgeting methods The capital budgeting methods can be regarded as an important factor in the process of business decision making (Fama 2016). Vital decisions on investment are essentially based on the returns from the investments generated unless the decisions of investments are for social reasons. These techniques of capital budgeting is essential as huge amount of money can be wasted in case if the investment turns out to be wrong or in other words uneconomical (Shapiro 2015). Thus, for the purpose of decision making in business it is vital to understand the significance of the capital budgeting techniques that businesses use for determination of the merits as well as demerits of investment projects of a business concern (Ryan and Ryan 2013). The techniques of capital budgeting follows an organized and well thought out step by step procedure that can assist a firm to cultivate as well as formulate strategic objectives for long term, pursue for new investments projects, approximate and estimate flows of cash in the upcoming period (Clark et al. 2014). In addition to this, this process also helps in facilitating the overall transfer of information, tracking and control of expenditures along with creation of business decisions. The process of business decision making can be associated to the procedure of evaluation of different proposals of capital investment. This essentially refers to techniques, namely, the net present value (NPV) along with internal rate of return among many others. The capital budgeting technique of NPV refers to the inflow (arrival) of cash that is anticipated to be generated at different periods of time is necessarily discounted at a specific rate (Fama 2016). Thereafter, the present values (PV) of th e influx of cash are associated to the original investment. The PV of the influx of cash can be compared to the original venture and in case if the variance between the two is positive, then the firm can arrive at the decision to accept the specific project otherwise discard the same. This mechanism regards the overall time value of money that is again stable with the intention of intensification of owners profit (Schall et al. 2015). As such, the equation for the NPV based on the supposition of cash outflow in the initial year can be represented in the following manner: In this case, the Ai (i=1(n)) stands for the cash inflows and K represents the capital cost of a particular corporation and C is the proposal cost of investment and n is the anticipated life of the specific investment proposal. Another capital budgeting technique is the internal rate of return (IRR) indicates towards rate at which the net present value of a specific investment project is equal to zero (Myers 2014). In this procedure, the discounted inflow of cash equals the discounted outflow of cash. This mechanism of capital budgeting considers the time value of money and it tries to arrive at a rate of interest at which invested funds in the investment projects can be repaid out of the inflows of cash (Ryan and Ryan 2013). Nevertheless, the process of IRR is known as an internal rate as it depends primarily on the outlay as well as proceeds related to the investment projects and not a rate determined outside the investment. IRR can be determined by means of solving the equations presented below: The business decision makers can arrive at decisions using this capital budgeting technique and if the IRR exceeds the WACC then the project is profitable (Myers 2014). If IRR is exceeding the K (capital cost), then decisions of accepting the project can be undertaken. Again, in case if the IRR is below the k (capital cost), then the judgments regarding rejection of the investment proposal can be undertaken by the decision makers (Myers and Turnbull 2015). Explanation of the concepts related to Capital Budgeting Mechanisms Sensitivity Analysis Sensitivity analysis refers to a specific technique that can be utilized for determination of the way different values of a particular independent variable influences a specific dependent variable under a specified set of suppositions (Mao 2013). However, this mechanism can be utilized within particular limitations that count on the one or additional input variables, for example the consequences that alters rate of interests on prices of bonds. Sensitivity analysis is also regarded as what if simulation analysis that refers to the way of prediction of the consequences of a particular business decision given a specific range of variables (Klammer 2014). It is also considered as one of the most important tools for analysing the project risks that intends to recognize different numerical values of diverse risk events as well as their consequences and undertake quantitative appraisal of certain risks. This quantitative analysis of the overall likelihood of particular risks as well as the ir consequences permits in finding out the most plausible value losses as per the occurrence along with magnitude. Graham and Harvey (2013) opines that the sensitivity analysis aid the managers in assessment of the degree of sensitivity as well as responsiveness of NPV to diverse alterations in the variables that are used to enumerate the same. However, the NPV essentially depends on particular number of independent variables such as volume of sales, price of selling, variable costs, outlay, cost of investment, interest on different loans and rate of discounts among many others. Froot and Stein (2016) mentions that the sensitivity evaluation requires calculation of NPV under diverse suppositions for determination of the way NPV is responsive to different changing state of affairs. Thus, sensitivity analysis helps in discovering whether a specific project might fail and whether there is likelihood of a specific events within a project can lead to negative NPV. Figure 1: NPV and IRR (graphical presentation) (Source: Froot and Stein 2016) Scenario Analysis Scenario analysis refers to the procedure of analysing diverse business decisions by taking into account different substitute possible consequences. Dean (2014) states that scenario analysis is essentially designed to observe the outcomes of a particular activity under diverse set of facets. Again, scenarios need to be plausible enough for delivering an appropriate image of the consequences. Scenario analysis necessarily uses 3 different situations, namely, base incident, worst case as well as best case (Durnev et al. 2014). Nevertheless, the number as well as conditions of different scenarios in each and every analysis can differ. Particularly, it is an analytic mechanism for management of uncertainty and not a predictive mechanism. However, the primary intention of sensitivity analysis is not only to compute or else enumerate risk, but also to establish the responsiveness of (NPV) to different variables that can be utilized to compute it (Bierman Jr and Smidt 2013). Again, the noti on of evaluating a particular venture before binding reserves to it is to provide the executives of organizations the opportunity of having larger image of the worth of the venture that in turn can add to the entire success of the organization (Antle and Eppen 2015). Thus, it can be said that the sensitivity analysis helps in the process of directing the efforts of the management, finding the sources of planning information, automation as well as quality evaluation. 2. Explanation and identification of the similarities as well as variances Capital Asset Pricing Model (CAPM) v/s Capital Market Line (CML) Capital Asset Pricing Model (CAPM) is one of the models that describe the nature of association between systematic risk as well as anticipated return for specific assets especially in case of stocks (Schall, Sundem and Geijsbeek 2015). This model is extensively used in business for valuing of different chancy securities as well as generates expected return for assets whereby risk of those assets will be calculated from cost of capital. Formula of Capital Assets Pricing Model: The idea behind use of CAPM is that investors require compensating in two major ways involving worth of money as well as risk (Ryan and Ryan 2013). However, the time value of the invested money is indicated by risk-free rate in the given formula as well as compensating the financiers for assigning the money in a particular investment for specified period. Assumptions All investors focus on a single holding period as well as find ways in minimizing the expected utility of terminal wealth by selecting from the alternative portfolios based on each portfolio expected return as well as standard deviation (Myers 2014) All investors can easily borrow or in case lend an unlimited amount at a given risk-free rate of interest as well as there are no restrictions or short sales of an asset (Myers and Turnbull 2015) Investors posses homogeneous expectations. This means investors have identical estimates from the expected returns as well as variances and covariances from the assets whereby participants have equal and costless way in accessing the useful information (Mao 2013) All assets are infinitely divisible No transaction costs No Taxes All involved investors are price takers whereby they own buying and selling activity that will not affect stock prices (Klammer 2014) The quantities of all assets are given as well as fixed Capital Market Line Capital Market Line (CML) essentially appears within the CAPM for depicting the return rate for efficient portfolios that is depending on risk level termed as standard deviation (SD) for portfolio of the market as well as risk-free return rate (Graham and Harvey 2013). In other words, the CML is basically shaped by outlining a digression line from predominantly the point of interruption on the competent boundary to the point whereby standard return from a particular asset equals the risk-free return rate. Capital Market Line Equation Figure: Capital Market Line (Source: Froot and Stein 2016) Capital Market Line (CML) indicates that anticipated return rate on certain efficient portfolio equals with risk-free rate as well as risk premium. In other words, the optimal portfolio considering investors where point of tangency between Capital Market Line as well as indifference curve of the investors (Durnev, Morck and Yeung 2014). Similarity between CAPM and CML Capital Market Pricing Model comprises of attributes such as Efficient Frontier, CML, and SML in addition to Calculation of Beta (Dean 2014). CAPM is a broader theory as well as set of some unrealistic assumptions that produces the SML but involves ideas at the same time. CAPM has systematic risk (beta) on the x axis. It has been further viewed that Capital Market Line is an efficient frontier after taking into consideration risk-free asset that are added to the minimum variance portfolios such as the curvy line from where it includes all risk assets termed as Market Portfolio. Therefore, Capital Market Line has total risk volatility on x-axis (Bierman and Smidt 2013). The formula for CAPM is risk-free rate is represented by adding beta of the security or else portfolio and multiplied with the anticipated return from market after deducting risk-free rate return rate (Antle and Eppen 2015). In other words, the yield involves anticipated return earned from the specific security. This means beta of a particular security help in enumerating the systematic risk in addition to sensitivity based on market variations. This takes into consideration when the market upsurges or else drops whereby security rises or else reduces within time. Security with a specific beta can be exceeding 1 as it bears more systematic risk as well as fluctuations than the market whereby security with a beta below 1 bears less risk that is systematic and market fluctuations. As such, the formula used in CAPM will help in determining when security can be considered for proper outlay by offering rational anticipated return for particularly the amount of risk assumed (Shapiro 2015). Capital Asset Pricing Model formula will be representing risk as well as calculate the compensation amount as per the investment requirements for assuming an added risk (Clark, Hindelang and Pritchard 2014). In other words, it is calculated by using risk measure in form of beta for comparing the returns of the assets to the market for specified time as well as market premium. This means market return is additional by assuming risk-free rate. This reveals the fact that beta reflects upon the manner a particular risky asset can be compared from the whole market risk from the fluctuations of a particular asset (Weingartner 2016). Difference between Capital Asset Pricing Model and Capital Market Line Capital Asset Pricing Model Capital Market Line CAPM is essentially an equilibrium model that shows the association between risk as well as required return rate for particular assets that is mentioned in the properly diversified portfolios (Fama 2016) Capital Market Line involves all linear combinations of risk-free assets as well as Portfolio CAPM is based on the premises that has only one factor Portfolio that is below Capital Market Line are inferior in nature that involves: The Capital Market Line defines the new efficient set (Durnev, Morck and Yeung 2014) All potential investors will select a portfolio on the Capital Market Line CAPM is one of the notions that will show association between risk as well as required rate of return on assets whereby the model embodies two elementary relationships such as Capital Market Line and Security Market Line (Durnev, Morck and Yeung 2014) The risk that is discussed in the model comes under two major components such as systematic risk as well as unsystematic risk CML indicates the connection that subsists between the proceeds whereby it should be projected on the effective portfolios of securities as well as risk of particular portfolio. In other words, efficient portfolios are effectual portfolios that will render maximum anticipated return for any magnitude of risk or lowermost magnitude of risk for any particular estimated return (Ryan and Ryan 2013). Conclusion The above study helps in gaining deep insight regarding capital budgeting techniques and the way the business decision making can be associated to particular techniques of capital budgeting. The present segment also provides an overview of the concepts of the NPV, IRR, sensitivity analysis as well as scenario analysis that helps in estimating the feasibility of projects. In addition to this, the current report also gives comprehensive understanding of the concepts of CAPM along with the capital market line that helps in understanding risk as well as anticipated return for specific assets. References Antle, R. and Eppen, G.D., 2015. Capital rationing and organizational slack in capital budgeting. Management science, 31(2), pp.163-174. 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