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Lecture 5 - Sensitivity Analysis Lecture Example

The document discusses a sensitivity analysis for a five-year project by Green Plc, which involves evaluating cash flows and determining the net present value (NPV) of the investment. It calculates the NPV, sensitivity percentages for various variables such as initial investment, selling price, material costs, labor costs, sales volume, and cost of capital, indicating how much each can change before the project becomes unviable. The analysis concludes that the most sensitive variable is the cost of capital, which can drop by 57% before the project is no longer viable.

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4 views3 pages

Lecture 5 - Sensitivity Analysis Lecture Example

The document discusses a sensitivity analysis for a five-year project by Green Plc, which involves evaluating cash flows and determining the net present value (NPV) of the investment. It calculates the NPV, sensitivity percentages for various variables such as initial investment, selling price, material costs, labor costs, sales volume, and cost of capital, indicating how much each can change before the project becomes unviable. The analysis concludes that the most sensitive variable is the cost of capital, which can drop by 57% before the project is no longer viable.

Uploaded by

dinhquynha1683
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Level 6: Financial Management – Lecture 5

Sensitivity Analysis

LECTURE 5 Example: Sensitivity Analysis Example


A five-year project has the following estimated cash flows:
Estimates:
Cost of equipment= £50,000, no residual value.
For 5 years, Annual demand=5,000 units.
For one unit: Selling price=£10;
Material costs=£3;
Labour costs=£4.
Cost of capital = 10%
Required:
(i) Should Green Plc invest in the new product? Ignore taxation.
(ii) A sensitivity analysis of the above variables.
The annuity factor for five years at 10% is 3.791.

(i) NPV Calculation:


Time Detail Cash flow (£) 10% D.F. Present Value (£)
0 Capital cost -50,000 1 -50,000
1-5 Sales revenue 5,000*10=50000 3.791 189,550
1-5 Material costs -5000*3=-15000 3.791 -56,865
1-5 Labour costs -5000*4=-20000 3.971 -75,820
NPV: 6,865

SENSITIVITY FORMULA:
Sensitivity % = (NPV/PV of variable) x 100

VALUE TO GIVE ZERO NPV:


FOR ANY COST, max value = Original Cost x (1 + sensitivity %)

FOR ANY INCOME/BENEFIT, min value = Original Value x (1 – sensitivity %)

VARIABLES:

1. INITIAL INVESTMENT:
Sensitivity % = (6,865/50,000)*100 = 13.73%

Value to give 0 NPV = 50,000*(1+13.73%) = £56,865


The initial investment can rise by 13.73%, up to £56,865k before the project is no longer viable.
Level 6: Financial Management – Lecture 5
Sensitivity Analysis

2. SELLING PRICE:
Sensitivity % = (6,865/189,550)*100 = 3.62%

Value to give 0 NPV = 10*(1-3.62%) = £9.64


The selling price can drop by 3.62%, up to £9.64/unit before the project is no longer viable.

3. MATERIALS:
Sensitivity % = (6,865/56,865)*100 = 12.07%

Value to give 0 NPV = 3*(1+12.07%) = 3.36


The material cost can rise by 12.07%, up to 3.36/unit before the project is no longer viable
4. LABOUR:
Sensitivity % = (6,865/75,820)*100 = 9.05%

Value to give 0 NPV = 4*(1+9.05%) = 4.36


The labour cost can rise by 9.05%, up to 4.36/unit before the project is no longer viable

5. SALES VOLUME (DEMAND): (use PV of net cash flows (Sales – Variables cost))
Sensitivity % = (6,865/56,865)*100 = 12.07%

Value to give 0 NPV = 5000*(1-12.07%) = 4,396 units


The selling price can drop by 12.07%, up to 4396 units before the project is no longer viable.

6. COST OF CAPITAL:
We know a 10% Cost of capital gives a +NPV of 6865

The Value which gives a 0 NPV is known as IRR

We therefore must guess a Cost of Capital which gives a negative NPV and interpolate

Try a rate of: 20%


Time Cash flow (£) % D.F. Present Value (£)
0 -50000 1 -50000
=(1-(1+0.2)^(-5))/0.2 =
1-5 15,000 44865
2.991
NPV: -5135

IRR = 10% + [6,865/(6,865 + 5,135) x (20% - 10%)]


= 15.7%.
Level 6: Financial Management – Lecture 5
Sensitivity Analysis

NPV = 0 = -50000+ 15000*(1+(1+IRR)^(-5))/IRR  IRR = ?

Therefore, the value which gives a 0 NPV = 15.7%

Sensitivity % = (15.7-10)/10*100=57%
The cost of capital can drop by 57%, up to 15.7% before the project is no longer viable

MOST SENSITIVE VARIABLES =

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