Rist in Financial Management - Essay Example

Many methods have been developed over the years to effectively appraise the investment proposals. These methods have been broadly bifurcated into two, namely Non- Discounting Method and Discounting Method. The main difference between these two is that discounting methods applies the concept of time value of money for the evaluation of proposals whereas the non-discounting methods do not. However, all methods primarily rely on the future cash flows of project/proposal, which are compared with the initial investment to carry out a cost benefit analysis.

In the cost benefit analysis of a project, the cash outflows incurred in connection with the project including working capital is compared with cash inflows to ascertain whether inflows outweigh outflows and vice versa. If the inflows exceed the outflows of a project, then the project will be suggested for acceptance, provided all other parameters are acceptable. But, there is a crucial issue in evaluating the project proposal which is not given much importance in any of the two mentioned methods.

This is related to the risks involved in the future cash flows on the basis of project selection/rejection is made. It is known for all that future cash flows from a project can be expected, but the question is how much or what is the volume of cash flows that are likely to be received from a project. There is an uncertainty in this regard and such an uncertainty is called risk in capital budgeting. Therefore, it is necessary to incorporate the risks involved in each project by certain methods.

Usually, the future cash flows are adjusted for the risks to incorporate the uncertainty with regard to its availability. The most commonly used three methods are:1. Scenario Analysis2. Break-even Analysis3. Decision Tree AnalysisScenario Analysis:"Scenario analysis is a method of assessing probable future occurrences by taking into account alternate probable consequences or scenarios. Scenario analysis was planned to enable quality decision making by appropriating more comprehensive conditions of results and what they entail.

" (Scenario Analysis. 2008). In scenario analysis, several variables are varied at a time. Most commonly three scenarios are considered: expected (normal) scenario, pessimistic scenario and optimistic scenario. In the normal scenario, all variables expect assume their expected values; in the pessimistic scenario, all variables value their pessimistic values; and in the optimistic scenario all variables assume their optimistic values. "The process of estimating the expected value of a portfolio after a given period of time, assuming specific changes in the values of the portfolio's securities or key factors that would affect security values, such as changes in the interest rate.

" (Scenario Analysis: What does Scenario Analysis Mean 2008). Break-even Analysis:"A break even analysis is a method, which denotes what is the ideal quantity of production and the minimal amount of sales to guarantee that there is no monetary loss of a project. Break even analysis forms an integral part of capital budgeting." (Break Even Analysis. 2008). In break-even analysis, the most important thing for the project appraiser is how much should be produced and sold at a minimum to ensure that the