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Sensitivity Analysis

The document discusses sensitivity analysis and break-even analysis for evaluating risky projects. It defines sensitivity analysis as estimating a project's net present value using pessimistic, most likely, and optimistic values for uncertain variables. Variables are selected based on management control and confidence in forecasts. The steps calculate NPV for each variable value while holding others constant. Break-even analysis finds the value of a variable where NPV is zero. The example calculates NPV for a new product, performs sensitivity analysis on key variables, calculates break-even points, and advises management on the investment.

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Ahmad Heri Setiyawan
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265 views10 pages

Sensitivity Analysis

The document discusses sensitivity analysis and break-even analysis for evaluating risky projects. It defines sensitivity analysis as estimating a project's net present value using pessimistic, most likely, and optimistic values for uncertain variables. Variables are selected based on management control and confidence in forecasts. The steps calculate NPV for each variable value while holding others constant. Break-even analysis finds the value of a variable where NPV is zero. The example calculates NPV for a new product, performs sensitivity analysis on key variables, calculates break-even points, and advises management on the investment.

Uploaded by

Ahmad Heri Setiyawan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Sensitivity Analysis 2016-2017

Learning Outcome

 understand the role of these sensitivity analysis in


project evaluation
 understand methods by which variables within a
project may be selected for sensitivity and break-
even analysis
 calculate the break-even values for the set of
selected variables
 make appropriate recommendations to assist
management in decision-making
Introduction To Sensitivity Analysis

 the process of analysing risky projects by estimating a


net presentvalue for each of the pessimistic, most likely
and optimistic values for each variable under
consideration
 Only one variable at a time is analysed, and all other
variables are held at their most likely value1
Steps In Sensitivity Analysis
1) Calculate the project’s net present value using the most likely value estimated for each
variable.
(2) Select from the set of uncertain variables those which management feels may have an
important bearing on predicted project performance.
(3) Forecast pessimistic, most likely and optimistic values for each of these variables over
the life of the project.
(4) Recalculate the project’s net present value for each of the three levels of each variable.
While each particular variable is stepped through each of its three values, all other
variables are held at their most likely values.
(5) Calculate the change in net present value for the pessimistic to optimistic range of each
variable.
(6) Identify the sensitive variables.
Selection of Sensitivity Variable
depends on
 Ability of management to control variables
 Management’s confidence in forecasts of
variables
 Historical experience held by management
 Variables which give rise to extrinsic project
benefits (tax)
 Time available for analysis and cost of
analysis
Approach in developing scenario

Forecast
Ad –hoc
Forecasting approach in
developing scenario
 Pessimistic and optimistic values established from
average values
 Pessimistic and optimistic values established from
extrapolated values
 Pessimistic and optimistic values established by
using management input
 Pessimistic and optimistic values established by
physical constraints
Adhoc approach

 Pessimistic and optimistic values are sometimes


set by selecting a standard positive and
negative percentage change around the
forecast value
 Detailed forecasts of the pessimistic and
optimistic values are not required.
 The process does not require any justification for
any particular extreme value so created. In the
computational sense, these sensitivity analyses
are relatively simple and straightforward
Break-even analysis

 Special application of sensitivity analysis. It endeavours to find the


value of individual variables at which the project’s NPV is zero.
 selected for break-even analysis can be tested only one at a time.
Management can select the particular variables by following the
guidelines given for sensitivity analysis.
Questions
 Pacific Products Inc. is considering the introduction of a new product, Alpha. The firmhas
gathered the following information relevant to the project:
 Initial fixed capital outlay: $120,000, Initial working capital outlay: $9,800
 Life of the project: 5 years
 Capital recovery at project end: fixed $18,000; working $7,200
 Sales units forecast: 50,000 units in year 1, growing at 6% per annum thereafter
 Unit selling price: $2.75
 Unit production cost: $1.28, Annual fixed overhead cost: $35,000
 Annual tax rate of depreciation claimable: 20% per annum, Annual income tax rate: 38%
 Required rate of return: 9% per annum
For these data:
(a) Calculate an NPV for the project under the given base-case scenario.
(b) Perform sensitivity analyses on the following variables: initial fixed capital outlay,unit selling
price, annual sales growth rate, unit production cost.
(c) calculate the break-even points for unit production cost and the required rate of return.
(d) Advise management of the analyses regarding the new product Alpha, and make
appropriate investment recommendations

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