Question

How do we determine if cash flows are relevant to the capital budgeting decision?

What are sensitivity analysis, scenario analysis, break-even analysis, and simulation? Why are these analyses important, and how should they be used?

Answer 1

Relevant cash flows are inflow and outflow of cash whose inclusion or exclusion from investment appraisal can affect the overall investment decision. What this means is that financial/ fund that have already been committed will not be considered while performing your capital budgeting.
Costs like To R & D, market research costs, old staff salary etc. will not be included as projected cash flow of project that will be considered for investment analysis purpose. The cost of feasibility studies for instance accepted or rejection of the project will not reverse cost. Understanding the principle behind the timing of cash flow will help you identify which cost is relevant and which one is not relevant.

Sensitivity analysis determines how different values of an independent variables affect particular dependent variable under a given set of Assumptions. Sensitivity analysis is used in business world and in the field of economics.
Scenario analysis is process of estimating the expected value of portfolio after a given period of time, assuming specific changes in the values of the portfolio's securities or key factors take places, Such as a change in the interest rate.
Simulation analysis is the process of developing a mathematical representation of an actual or proposed product in a computer model. Simulation analysis are used to model the probability of different outcomes in process that cannot easily be predicted due to the intervention of random variables.

Break even analysis entails the calculation and examination of the margin of safety for entity based on the revenues collected and associated costs. Analysis different price level relating to various level of demand a business uses break even analysis to determine what level of sales are necessary to cover the company's total fixed costs.

Sensitivity analysis is Financial model that determines how target variables are affected based on change in other variables known as input variables. It is way to predict the outcome of a decision given a certain range variables.
  Scenario analysis involves computing different reinvestments rate for expected returns that are reinvested within the investment horizons. Based on mathematical and statistical principles , scenario analysis provides a process to estimate shift in the value of portfolio, based on the occurrence of different situation , referred to as scenario, following the principle of what if analysis.

Simulation analysis performs risk analysis by building model of possible results by substituting a range of values a probability distribution for any factors that has inherent uncertainty. It than calculate results over and over, each ye using a different set of random values from the probability functions.
Break even analysis is useful in the determination of the level of production or targeted desired sales mix. The study is for management's use only, as metric and calculation are not necessary for external source such as investors, regulators or financial institutions.