Financial Relationship Essay

Question:

1.Explain the Following Concepts ?
A.Sensitivity Analysis
B.Scenario Analysis
2.Explain the Following Model ?
A.Capital Asset Pricing Model.
B.Capital Market Line.

Answer :

Introduction

This assignment mainly provides the answers of two questions. While answering the first question, the study discusses on the relationship between the capital budgeting techniques like, Internal Rate of Return and Net Present Value method and managerial decision making process. At the same time, the answer also includes the discussion regarding the concepts of sensitivity analysis and scenario analysis in relation to capital budgeting techniques. The answer in the second question defines the similarities and dissimilarities between the Capital Assets Pricing Model and Capital Market Line.

Question 1

The capital budgeting techniques like, Internal Rate of Return and Net Present Value analysis are most popular methods that help the management of the companies taking logical investment decisions (Robinson and Burnett 2016). The internal rate of return is a capital budgeting technique that helps to identify the percentage of return that the management or the company will get by investing in a particular project. While calculating the internal rate of return, the management considers future cash inflows and out flows of that project. In the words of Abor (2017), the internal rate of return or IRR either motivates or de-motivates the investors or the management towards a particular project. The identification of IRR percentage of the project also indicates the breakeven point of the project. Hayward et al. (2016) suggests that if the value of IRR is higher than the cost of finance, then the project can be consider as an attractive project. This means, by identifying the IRR, the management can understand whether the project is suitable for them or not.

Net Present Value or NPV is another capital budgeting method that helps to identify the present value of certain future course of action or the future project (Magni, Veronese and Graziani 2016). In order to identify the NPV of a particular project, the future cash flows and discounting rate are considered. In case of a particular project, if the NPV value is positive, then it is considered that the project will be able to generate positive cash inflows in future years when the project will be completed (Tong, Hu and Hu 2017). Therefore, like, IRR, the NPV also helps the management understanding whether the project will be profitable for the company or not.

Concept of sensitivity analysis in relation to capital budgeting technique

Sensitivity analysis is a concept that helps identifying the impact of different values of independent variable on the dependent variable under certain circumstances (Christina 2009). On the other side, capital budgeting is a technique of analyzing a particular project in order to determine whether the project must be taken or not. Berk and Van Binsbergen (2016) have mentioned that the sensitivity analysis is related to the capital budgeting techniques to some extent. In case of the sensitivity analysis in general context, the management analyzes the project by considering both financial as well as non-financial factors, whereas in the capital budgeting, the management considers only the financial factors while analyzing a particular project (Anderson and Linderoth 2016). This indicates that the sensitivity analysis in relation to capital budgeting is that through which the management analyzes the financial factors of a project.

In the other words, it can be said that through sensitivity analysis, the management of a company identifies or determines the probability of getting success in a particular project. Habibi, Habibi and Habibi (2016) has defined the sensitivity analysis as the technique of identifying or budgeting the cash inflow and outflow of a particular project by considering some essential factors like, interest rate, current economic condition and inflation rate. The sensitivity analysis in relation to capital budgeting can be better done with the help of IRR and NPV methods (Robinson and Burnett 2016). For example, in a particular project, the management of a company identified the IRR 10%, where the cost of capital is 5%. This means the IRR is much higher than the cost of capital or finance cost. Therefore, there is more chance or probability that the project will be profitable or suitable for the company because the rate of return that the investor or the company will get will be high. Similarly, if the company identifies that the net present value of the project is negative, then the probability of project failure will be high, which means the management must not invest in the project (Christina 2009).

Concept of Scenario analysis in relation to capital budgeting technique

Scenario analysis is a technique of analyzing a particular project by considering certain factors and assumptions. In the other words, it can be said that the scenario analysis is a technique of analyzing a project by considering variety of situations or scenarios. Berk and Van Binsbergen (2016) commented that the scenario analysis helps the management of a company analyzing each possible alternative outcome of a particular project. Habibi, Habibi and Habibi (2016) have mentioned that the scenario analysis helps the managers identifying the value of a project by considering each risk factor. With the help of the scenario analysis, the management can understand impact of any unfavorable situation on the particular project taken by the company (Anderson and Linderoth 2016). For example, while investing in a new project like, business expansion, the management of the Woolworths Limited conducts the scenario analysis in order to identify the possible risks and return percentage of the project.

Before starting or investing a particular project, it is very important conducting the scenario analysis of the project. In case of any particular investment project, the company can conduct the scenario analysis by identifying the IRR and NPV by considering different rates of cost of capital (Tong, Hu and Hu 2017). At the same time, the management can also conduct the scenario analysis by identifying the IRR and NPV at different economic situations like, identifying the IRR and NPV during the high inflation in the market and identifying the IRR and NPV by considering the depression in the market (Christina 2009). Scenario analysis through capital budgeting techniques helps the management conducting realistic analysis of the project, which ultimately helps taking quick and appropriate decision.

Therefore, from the above analysis, it can be understood that sensitivity analysis and scenario analysis both are important for the management while taking any decision related to capital investment. These two analytical concepts are very effective in case of capital budgeting. These two concepts help analyzing the project under realistic scenario.

Question 2

Identifying the similarities and differences between Capital Assets Pricing Model and Capital Market Line

Before identifying the similarities and dissimilarities between Capital Assets Pricing Model or (CAPM) and Capital Market Line, it is important to have a basic knowledge on these two concepts, which are stated below:

The main motive of CAPM model is identifying the relationship between the systematic risk and the expected return from a particular investment or asset (Lal et al. 2016). While analyzing a particular project with the help of CAPM, the management requires considering both of the systematic and unsystematic risk factors. Prat (2016) has considered the CAPM as one of the most suitable model for analyzing the suitability of a particular financial or investment project. In order to identify the expected return through the CAPM model, the following formula will be followed:

Re = Rf + B [E (Rm) – Rf]

Rf = Risk free rate of the securities

Re = Return on equity

B = Beta coefficient and

E (Rm) = Expected rate of return on the portfolio of market

B [E (Rm) – Rf] = The difference between the rate of risk- free rate and the anticipated return of market security that is referred as market premium.

On the other side, the Capital Market Line shows the market portfolio of a particular set of risky assets. This is a tangent line that represents the value of the risks factors in a particular project. The Capital Market Line starts from the point, where the investment project is risk free and ends to the point, where the risks in the project starts (Kianpoor and Dehghani 2016). The Capital Market Line indicates the risk factors in a project that helps the CAPM model determining the fair value of the investment or project in respect to the current market value (Do, Bhatti and Konya 2016). Moreover, the Capital Market Line helps determining the level of performance of a particular assets portfolio. The Capital Market Line for a particular investment portfolio indicates whether the portfolio is overvalued or under-valued. The securities under a portfolio can be considered as under-valued if the expected rate of return of the security against the risk component that is beta is drawn above the Capital Market Line and vice-versa (Kianpoor and Dehghani 2016).


The major similarity between Capital Assets Pricing Model and Capital Market Line is that both help to determine the return from a particular investment or portfolio (Christensen, Hail and Leuz 2016). In case of the CAPM, the expected return on investment is measured based on the expected market return, risk variance and risk free rate of return (Lal et al. 2016). On the other side, in case of the Capital Market Line, the expected return is measured by identifying the tangent line by considering the CAPM.

Another similarity between these two is that the both consider the risk factors while determining the return. As stated above, in case of CAPM, two types of risks are considered – systematic risk and unsystematic risk (Petters and Dong 2016). On the other side, as the Capital Market Line is determined by considering the CAPM, it also considers the systematic as well as unsystematic risk. In the words of Prat (2016), the expected return from a project or investment which is determined by the CAPM model, is represented by the Capital Market Line.

Though there are some similarities between the Capital Assets Pricing Model and Capital Market Line, it cannot be said that these two are completely same. There are some differences between these two. The first difference is that the Capital Assets Pricing Model determines the expected return of the investment portfolio by considering the risk free rate, systematic risks and the market premium rate; whereas, the Capital Market line determines the value of the investment portfolio by considering the probable return and risk factors (Christensen, Hail and Leuz 2016). Another difference between these two is that the Capital market line is just a graphical representation of value of the securities in the investment portfolio, but the CAPM does not provide any graphical representation that identifies the expected returns for the investment portfolio of a particular investor (Petters and Dong 2016).

The capital market line depends on the CAPM model because while determining the Capital Market Line, the CAPM formula is followed in order to identify the expected return of the particular investment portfolio (Do, Bhatti and Konya 2016). However, the Capital Assets Pricing Model is not depended on the Capital Market line. Therefore, it can be said that CAPM is a part of Capital Market Line but Capital Market Line is not a part of CAPM model. In case of the Capital Market Line, only the efficient portfolios are shown. In the other words, it can be said that the Capital Market Line represents only those portfolio, which are efficient and include high return. However, this cannot be applied in case of the CAPM model (Christina 2009).

Therefore, from the above discussion, it can be said that CAPM and Capital Market Line are related to each other but they are not completely same.

Conclusion

In this study, it has been identified that the Internal Rate of Return and he Net Present Value are the two most effective methods of capital budgeting. The study has identified that the internal rate of return and the net present value help the management of the companies to determine whether they should invest in a particular project or not. At the same time, the study has also identified that the management of an organization may conduct the sensitivity analysis and scenario analysis based on the capital budgeting techniques like, IRR and NPV. As per the analysis in the study, the sensitivity and scenario analyses help to determine the feasibility and suitability of the project in the real scenario.

The study has also indicated that the capital assets pricing model and the capital market line both aim to identify the expected return of an investment portfolio and at the same time, these two also consider the risk factors while determining the expected return. However, the capital market line is a graphical representation of value of the securities in the investment portfolio, which is not same in case of the capital assets pricing model.

Reference list:

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