Thursday, May 19, 2022

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    Do you analyze the risk?

    Risk is an inherent part of every business, when it comes to making decisions regarding capital budgeting, they involve cost and benefits for a long period of time. Risk analysis is one of the most typical aspects of capital budgeting. There are various types of risk such as project-specific risk, competitive risk, industry-specific risk, market risk, etc. Now to evaluate the uncertainties we have various techniques like Sensitivity Analysis, Scenario Analysis, Break Even Analysis, Decision Tree Analysis, and Simulation Analysis. 

    when any capital budgeting plan is made there are various options to be analyzed like the investment, sales, variable cost, fixed cost, and taxes. The slightest change in any of these variables can cause a change in the entire capital budgeting decision. The First method is sensitivity analysis or “what if” analysis. under that, we measure the change of one variable and its effect on Net Present Value. NPV is the addition of all the cash flows deducted from the initial investment.  the sensitivity of a variable we define the optimistic and Pessimistic scenarios for the variable. 

     the next commonly used technique is Scenario analysis.  this technique holds command over the above-mentioned variables like sales, variable cost, fixed cost, depreciation, profit, etc. by simultaneously measuring several variations, also giving a broader view for forecasting our expected values.  

    The third technique is break-even analysis. As the name suggests, any financial specialist might be interested in knowing what is the minimum cost to be earned through sales so as to cover the fixed cost, depreciation charges, and other complementary costs.  Here we ponder upon the upside or the downside changes in sales. This kind of analysis is called a Break-Even Analysis and the point where the loss gets avoided is called the Break-Even Point.

    These are some of the techniques available to overcome the various risks.

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