Business Organizations Sensitivity and Scenario

Question: Discuss about the Business Organizations Sensitivity and Scenario. Answer: Introduction In current, most of the business organizations use sensitivity and scenario analysis to make their corporate decisions in an accurate manner. Along with this, they also involve capital budgeting techniques such as: Internal Rate of Return (IRR), Net Present Value (NPV), etc. in the sensitivity and scenario analysis of the organizations. The major reason behind it is to make accurate corporate decisions for the financial growth of the company. Moreover, this research essay would be useful to describe the concepts of sensitivity and scenario analysis with regard to capital budgeting techniques. Apart from this, this essay would also express the similarities as well as differences between the Capital Asset Pricing Model (CAPM) and Capital Market Line (CML). Sensitivity and Scenario analysis In the context of business finance, both sensitivity and scenario analysis are important components that are used to make important financial decisions. Business organizations use these analyses to decide whether or not to make investments. Along with this, businesses use one of these models to make investment decisions and also to make corporate budgets in order to use available funds in a systematic and an appropriate manner (Grimvall, Holmgren, Jacobsson Theden, 2009). Moreover, both sensitivity and scenario analysis and their relations to the techniques of capital budgeting is discussed below: Sensitivity Analysis: Sensitivity analysis is an important accounting tool that is used by business organizations to decide that how different values of an independent variable have an effect on a particular dependent variable in a specified set of assumptions. A sensitivity analysis is also used to comprehend the impact of different variables on the given outcomes of the organizations (Ehrhardt Brigham, 2008). Apart from this, the key purpose of sensitivity analysis is not only to evaluate risk but also to determine the receptiveness of net present values to variables that are applied to calculate it. Moreover, in corporate finance, sensitivity analysis is important to evaluate that how the input variables in capital budgeting decisions influence the net present value (NPV), internal rate of return (IRR) or some other outputs. This thing shows that there is a strong relation between sensitivity analysis and capital budgeting techniques such as: NPV, IRR, etc. (Whittington Delaney, 2007). Sensitivity Analysis and Its Relevance to NPV and IRR: Sensitivity analysis makes use of the capital budgeting techniques (NPV and IRR) to evaluate an investment project. In other words, it also can be said that the capital budgeting techniques are essential to conduct a sensitivity analysis effectively. For example, business corporations have need of forecasts cash flows, and expected revenue costs to evaluate an investment project properly. In this situation, business firms use capital budgeting techniques (NPV and IRR) to forecast various variables and to determine the cash flows of the project (Damodaran, 2010). Along with this, the consistency of NPV or IRR of the investment project only depends on the dependability of the variables that are essential to estimate net cash flows. Moreover, to decide the NPV or IRR of a project, business firms find out all the differences that may occur if any forecast goes erroneous. Business firms also use three values such as: expected, pessim istic and optimistic to make changes in forecasts. They also recalculate the NPV or IRR under these different accounts. The way of re-computing the NPV or IRR by using these three values is known as sensitivity analysis (Baker Powell, 2009). Along with this, sensitivity analysis plays a major role to evaluate the changes in the NPV or IRR of a project according the changes in the given one or more variables. A sensitivity analysis also signifies the sensitivity of a projects NPV/ IRR in view of changes in variables (Crundwell, 2008). The more sensitive NPV or IRR points out that the variable is also more critical. Moreover, business corporations use the following steps to determine the sensitivity of a project and these steps specify the relevancy between sensitivity analysis and the techniques of capital budgeting: Identify all the variables that may have an effect on the NPV or IRR of a project; Define the core relationship among the given variables; Examine the impact of variables changes on the NPV or IRR of a project (Massari, Gianfrate Zanetti, 2016). In view of that, it can be said that, the decision making of companies could be linked to the techniques of capital budgeting. Moreover, it also can be said that, these capital budgeting techniques have their importance in the sensitivity analysis as well. Scenario Analysis: In finance, scenario analysis is a key accounting method that is used to forecast future values of portfolio investments on the basis of prospective events. Moreover, the analysis also plays a major role to evaluate that how a situation can affect outcomes of portfolio investments. Scenario analysis is widely used in the situations of high risks and high uncertainty. It is also useful to determine the best and worst scenarios and also to disclose the outcomes that have been disregarded by the business organizations (Doss, Sumrall III, McElreath Jones, 2013). Scenario Analysis and Its Relevance to NPV and IRR: Same as the sensitivity analysis, scenario analysis has its impact on the capital budgeting techniques (NPV or IRR). It is because of business corporations make use of scenario analysis in order to establish the net present value or internal rate of return of a potential investment in the situation of high or low inflation scenarios (Lasher, 2016). In capital budgeting, the key idea of risk is totally related to the cash flows of the projects. They do not work the same as estimated. In this situation, the actual NPV or IRR may be different from projected. AT that time, the changes in NPV or IRR become a major subject of concern to the business associations. They estimate that how much an NPV or IRR may change due to the differences in cash flows. In this situation, scenario analysis plays a significant role to establish relationship between the changes of cash flows and their NPVs or IRRs. Along with this, scenario analysis does not only examine the sensitivity of NPV or IRR; but also evaluates the prospect distribution of the variables to provide higher returns to the business organizations (Grimvall, Holmgren, Jacobsson Theden, 2009). In this way, it can be assumed that, scenario analysis has a wide impact on the capital budgeting techniques. Capital Asset Pricing Model and Capital Market Line The CAPM model (Capital Asset Pricing Model) is one of the important models in the area of finance. The business organizations use the CAPM model to estimate the required rate of return (ROR) for any risky asset. Along with this, the CAPM model portrays the relationship between systematic risk and projected return for assets. Business associations widely used the CAPM model to determine price of risky securities (individual security or portfolio), generate projected returns for asset and also calculate costs of capital accurately (Lee Lee, 2010). Moreover, the CAPM model works on a standard formula that depicts the relationship between risk and expected return. The formula is given below: On the other hand, CML (Capital Market Line) is an important concept of the CAPM model. It plays a significant role to portray the level of added return beyond the risk-free rate for amends in the level of risk. The capital market line emerges in the CAPM model to represent the rates of return (ROR) for efficient portfolios that depends on the risk level and the risk-free ROR for a market portfolio. The capital market line is a type of graph that is given below: On the other hand, there are numerous similarities as well as differences between the capital asset pricing model and capital market line. These are discussed as below: Similarities: There are numerous similarities between capital asset pricing model and capital market line. For case, the major similarity is that both are the important concepts of corporate finance. Along with this, the other major similarity is that both models are used to compute the expected return of a portfolio or security (Elton, Gruber, Brown Goetzmann, 2009). Both CAPM and CML are equally useful for business associations in order to determine that they should consider an investment or not. The investment would be able or not to provide expected return for the investment amount. Both CAPM and CML are related to each other. It is because of CAPM and CML depicts the correlation between the expected return and systematic risk that are linked with a security or portfolio. In this way, it can be said that, both CAPM and CML models are used to determine the systematic risk and expected return of a security. Both CAPM and CML are useful to decide that an investment in a security or portfolio is logical or not (Jones, 2016). Hence, it can be assumed that, both CAPM and CML have numerous similarities with one another. Differences: There are a few differences between capital asset pricing model and capital market line. For example, the major difference is that CAPM model calculates the systematic risk and expected return for a security or a portfolio. In contrast, the capital market line graphically represents the systematic risk and expected return for a portfolio (Maghrebi, Mirakhor Iqbal, 2016). Apart from this, CAPM model does not use capital market line to calculate the risk and return of a portfolio. But, the capital market line makes use of CAPM formula to analyze the risk and return of a security/portfolio. It represents the formula of CAPM in a graphical manner. The capital market line sketches the relationship between the projected return and systematic risk that are linked with a security. On the other hand, the other major difference between capital asset pricing model and capital market line is that the CAPM model is a part of portfolio theory whereas the capital market line is a part of CAPM model. The capital market line is used in the capital asset pricing model to demonstrate the return that can be achieved by investors all the way through investing in a risk free asset (Hagstrom, 2013). Along with this, the CML illustrates the levels of risk as well as return in a very clear way. The level of return increases only when the level of assumed risk also increases. Furthermore, another major difference is that with the help of the CAPM model, investors only calculate profits on their investments. Despite the fact that, with the help of CML, investors make final decisions about their investments. For this reason, it can be assumed that, there are some differences between the CAPM and CML. Conclusion On the premise of above discussion, it can be said that, both sensitivity and scenario analysis play a significant role in the decision making process of the business corporations. Along with this, it is also examined that, sensitivity and scenario analysis have relationship with the capital budgeting techniques NPV and IRR. Both, sensitivity and scenario analysis includes NPV or IRR of projects to make important decisions related to investments. Moreover, it is also observed that, both analyses play a major role to determine and evaluate possible returns as well as events that can occur in the future. Apart from this, it is also viewed that, the capital asset pricing model and capital market line are also important concepts of the business finance. Both CAPM and CML are useful to calculate the expected risk and return of a security or portfolio. Moreover, it is also seen that, CAPM and CML are interconnected to one another. 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