SENSITIVITY ANALYSIS

SENSITIVITY ANALYSIS

By the end of this lesson, you will be able to

• Apply investment appraisal techniques to a range of capital budgeting scenario

• Able to make appropriate recommendations

So now, let's rewind our past discussion

WHAT IF?

Sensitivity analysis typically involves asking ‘what if?’ questions.

WHAT IF?

For example, what if demand fell by 10% compared to our original forecasts? Would the project still be viable?

FORMULA =

To make a better understanding, let test our knowledge....

Here is a given situation

• You are considering an investment that would cost you RM7,000,000

• Sales of the product is expected to be RM6,500,000 for the next TWO (2) years

• Fixed cost is RM 2,000,000

• Discount rate is 8%

So what is the NPV of this investment?

Multiple Choice

Let's check the PV for our initial investment. Which one is the correct one?

• (-7,000,000) X 1 = (-RM7,000,000)

• 7,000,000 X 1 = RM7,000,000

INITIAL INVESTMENT = (-RM7,000,000)

Remember! Initial investment is our cost. So it is a negative value.

Multiple Choice

Sales of the product is expected to be RM 6,500,000 for the next TWO years. Your Discount rate is 8%

Now calculate PV for your Cash Flow.

• 6,500,000 X 1.783 = 11,589,500

• 6,500,000 x 0.857 = 5,570,500

PV for Cash Flow = RM 11,589,500

Remember! Cash Flow is consistent and you must use PV Annuity table

Multiple Choice

Next step, calculate PV for your Fixed Cost. (Fixed cost = RM 2,000,000

• (-2,000,000) x 1.783= (-RM3,566,000)

• 2,000,000 x 1.783= RM3,566,00

PV for Fixed Cost = (-RM3,566,000)

Yes correct! It is a cost ,thus it is a negative value.

What is our next step?

You have calculated PV

Year 0 = Initial Investment =(RM 7,000,000)

Year 1 -2 = Cash Flow = RM 11,589,500

Year 1 -2 = Fixed Cost =(RM 3,566,000)

Multiple Choice

Now calculate your NPV.

• (-7,000,000)+11,589,500+(-3,566,000) = RM1,023,500

• 7,000,000+11,589,500+3,566,000 =

  RM22,155,500

Multiple Choice

You NPV is RM1,023,500

Should we accept this project?

• Totally NO NO NO!

• YES we should!

Your NPV is RM1,023,500

Because it is a POSITIVE, we should accept this project because it brings us PROFIT!

Now it is time to calculate Sensitivity Analysis

Multiple Choice

Before that, let's recap the formula

• $$NPV\div\ PV\ of\ CF\ under\ consideration$$  

• $$PV\ of\ CF\ under\ consideration\ \div\ NPV$$  

FORMULA

Multiple Choice

Calculate your SENSITIVITY ANALYSIS of your INITIAL INVESTMENT

Year 0 = Initial Investment =(RM 7,000,000)

Year 1 -2 = Cash Flow = RM 11,589,500

Year 1 -2 = Fixed Cost =(RM 3,566,000)

NPV is RM1,023,500

• (RM1,023,500 ∕RM7,000,000 ) x 100 = 14.6%.

• (RM7,000,000 ∕ RM1,023,500) x 100 = 7.17%.

Your sensitivity to INITIAL INVESTMENT IS 14.6%

• Therefore, the initial investment can rise by 14.6% before NPV becomes negative

Multiple Choice

Calculate your SENSITIVITY ANALYSIS of your CONTRIBUTION

Year 0 = Initial Investment =(RM 7,000,000)

Year 1 -2 = Cash Flow = RM 11,589,500

Year 1 -2 = Fixed Cost =(RM 3,566,000)

NPV is RM1,023,500

• (RM1,024,850 ∕3,566,000 ) x 100 = 28.7%

• (RM1,023,500 ∕11,589,500 ) x 100 = 8.83%

Your sensitivity to CONTRIBUTION IS 8.83%

• Therefore, the selling price can fall by 8.83% before NPV becomes negative.

Multiple Choice

Calculate your SENSITIVITY ANALYSIS of your FIXED COST

Year 0 = Initial Investment =(RM 7,000,000)

Year 1 -2 = Cash Flow = RM 11,589,500

Year 1 -2 = Fixed Cost =(RM 3,566,000)

NPV is RM1,023,500

• (RM1,023,500 ∕3,566,000 ) x 100 = 28.70%

• (RM1,024,850 ∕11,591,450 ) x 100 = 8.84%

Your sensitivity to FIXED COST IS 28.7%

• Therefore, operating costs can rise by 28.7% before NPV becomes negative.

NEXT you have to calculate sensitivity to COST OF CAPITAL

But before that , you need to calculate your IRR

Multiple Choice

NPV 1 = RM1,023,500 //R1 = 8%

NPV 2 = ? // R2 = 20%

TRY FIND NPV 2?

Year 0 = Initial Investment =(RM 7,000,000)

Year 1 -2 = Cash Flow = RM 6,500,000

Year 1 -2 = Fixed Cost =(RM 2,000,000)

(annuity table; Year 2 = 1.5278)

• 5,260,366

• -128,500

Multiple Choice

NOW CALCULATE YOUR IRR.....

• 15.69%

• 18.66%

Recommendation

This means that cost of capital can increase by 18.66% before NPV becomes negative.

Poll

How is your feeling right now?

• It was easy. I can understand all of it!

• Need more practice

PROBABILITY ANALYSIS

Let's rewind a little bit about probability analysis

PROBABILITY ANALYSIS

• When there are several possible outcomes for a decision and probabilities can be assigned to each, a probability distribution of expected cash flows can often be estimated. 

• This recognises there are several possible outcomes, not just one.  

The FORMULA for calculating an EV is

EV =∑px

PROBABILITY ANALYSIS

You have to chose between 3 mutually exclusive project

Multiple Choice

WHICH PEOJECT SHOULD WE CHOOSE?

PROJECT 3 should be undertaken

However it should be noted that Project 3 is also the most risky option as it has the widest range of potential outcomes.

Poll

Now I'm able to apply investment appraisal techniques (SENSITIVITY AND PROBABILITY ANALYSIS) to a range of capital budgeting scenario

• YES!

• NOT YET

Poll

Now I'm able to make appropriate recommendations

• YES!

• NOT YET