SENSITIVITY ANALYSIS The NPV of a project is based upon the series of cash flows and the discount factor.

both these determinants depends upon so many variables such as sales revenue, input cost, competition etc .given the level of all these variables there will be a set series of cash flows and hence there will be a NPV of the proposal. If any of these variables changes the value of the NPV will also change. It means that the value of NPV is sensitive to all these variables. However the value of NPV will not change in the same proportion for a given change in any one of these variables. For some variables the NPV may be less sensitive while for others the NPV may be more sensitive. The sensitivity analysis deals with the consideration of sensitivity of the NPV in relation to different variables contributing to the NPV. The following steps are required to apply the SA to capital budgeting proposal:
a)

b)

c)

Based on the expectations for the future, the cash flows are estimated in respect of the proposal. NPV of the proposal is calculated on the basis of these cash flows. To identify the variables which have a bearing on the cash flows of a proposal .For example some of these variables may be the selling price, cost of inputs, market share, market growth rate etc. To find out the effect of change in any of these variables on the value of NPV. This exercise should be performed for all the factors individually. For example in case of a project involving the product sale, the effect of change in different variables such as number of units sold, selling price, discount rate etc. can be taken up on the NPV or IRR of the project. This information can be used in conjunction with the basic capital budgeting analysis to decide whether or not to take up the project.

Example ABC and CO. is evaluating two proposals A1 and A2 both having cash out flow of Rs 30,000 each. However these alternatives proposals may result in different cash inflows depending upon different economic condition i.e good average and poor. The following information is available-

ECONOMIC LIFE CASH INFLOWS(ANNUAL) GOOD ECO.CONDITION AVERAGE ECO.CONDITION POOR ECO.CONDITION

A1 10 YEARS RS 8000 RS 6000 RS 4500

A2 15 YEARS RS6000 RS 5500 RS 4500

Evaluate the proposals and advise the firm given that the minimum required rate of return of the firm is 10%. Solution: As the three estimates of cash flows are given for different economic condition the NPV of the proposals should also be calculated under all the three conditions. Further the cash flows are in the form of annuity of 10 years for proposal A1and for 15 Years for proposal A2. The relevant PVAF(10%,10y) and PVAF(10%,15y)are 6.145 and 7.606 respectively. The present values of the cash flows may be calculated as follows:

Proposal A1 CF PVAF Good Condition Average Condition Poor Condition 8,000 6,000 4,500 6.145 6.145 6.145

PV 49,160 36,870 27,653

Proposal A2 CF PVAF 6,000 5,500 4,500 7.606 7.606 7.606

PV 45,636 41,833 34,227

Calculation of NPV of proposals:

Proposal A1 Pv outflow Good Condition Average Condition Poor Condition 49,160 36,870 27,653 30,000 30,000 30,000

NPV 19,160 6,870 (2,347)

Proposal A2 pv outflow 45,636 41,833 34,227 30,000 30,000 30,000

NPV 15,636 11,833 4,227

The proposal A2 is better and hence should be selected. The proposal A2is having positive NPV under all the three types of economic conditions, whereas the proposalA1may have a negative NPV in case the economic conditions become poor. so, the proposal A1is risky as compared to proposal A2. In the example 9.1 the situation was over simplified by taking effect of cash flows on the value of the NPV. However the same procedure can be extended and the effect of change in different variables on the value of NPV can be identified .The sensitivity of a capital budgeting proposal in general may be analyzed with reference to (1) level of revenues (2) The expected growth rate in revenues (3)the operating margin and (4) the working capital requirements as a percentage of revenue etc. with each such variable the NPV and IRR of a proposal may be ascertained by keeping the other variables unchanged. Example 2 illustrates this point. EXAMPLE 2 The following forecast are made about a proposal which is being evaluated by a firm. Initial outlay RS.12, 000 Life 4 years PVAF (14%, 4Y) =2.9137PVAF (14%,3Y) = 2.3216 cash inflows RS. 4,500(annual) ke 14%

SOLUTION The NPV of the project is NPV =-12,000 +4,500 x (2.9137) = RS 1,112 Now the sensitivity of different variables with respect to this value of NPV (RS 1,112) may be analyzed as follows: 1. Sensitivity with respect to initial outlay: Since NPV is RS 1,112 therefore the outlay can increase from RS 12000 to RS 13,112 i.e RS 12000 RS 1,112 before the NPV becomes zero. Therefore there is a margin of RS 1,112 or 9.4% of the initial outlay. Margin for initial outlay =(1,112/12000) x 100 =9.4% 2. Sensitivity with respect to annual cash inflows: The PVF(14%,4Y) = 2.9137 Therefore 12000 =Annual inflows x 2.9137 Therefore Annual inflows =4,118. There the annual cash inflows can decrease from the present level of RS. 4, 500 to RS. 4,118 before the NPV becomes 0. So the annual cash inflows have a margin of RS 382(i.e RS 4,500 RS 4,118) or 8.5%(i.e 382/4,500 x 100) 3. Sensitivity with respect to discount rate: say the discount rate at which the NPV is 0,is x Therefore RS 12000 = 4,500xx Therefore, x =2.667 The PVAF of 2.667 for 4 years period is approximately found in 18% column in the PV AF table. The discount rate can increase from the present level of 14 % to 18%before the NPV becomes negative. Therefore there is a margin of 4%(i.e 18% -14%) or 29%(i.e 4/14 x 100).

The above analysis shows that the project is so sensitive to the annual cash inflows and even a change of 8.5%in the cash inflows can make the project as unviable. It may be tempting to change each & every variable in order to analyze the sensitivity of the proposal, however it may be relevant to focus only on two sets of variables in particular i.e (1)those that matter the most in terms of affecting the cash flows (2)those that matter the most for uncertainty e.g the operating margin. SA helps in identifying the different variables having effect on the NPV of a proposal. It helps in establishing the sensitivity or vulnerability of the proposal to a given variable and showing areas where additional analysis may be under taken before a proposal is finally selected. The final decision on whether or not to take the proposal will be based on the regular capital budgeting analysis and the information generated by the sensitivity analysis. It is entirely possible that a decision maker, when faced with the results from the SA might decide to override a proposal originally approved by capital budgeting analysis. He may point out that a small change in any one variable makes the proposal unacceptable. Limitations of sensitivity analysis: 1) It may be observed that the SA is neither a risk measuring nor a risk reducing technique. It does not provide any clear cut decision rule. 2) Moreover the study of effect of variations in one variable by keeping other variables constant may not be very effective as the variable may be interdependent. In a practical situations the variables are often related and move together e.g the selling price and the expected sales volume are interrelated. 3) The analysis present results for a range of values, without providing any sense of the likelihood of these values occurring.

CAPITAL BUDGETING AND OPTIMUM REPLACEMENT TIMING Sometimes a firm may be engaged with taking a very particular capital budgeting decision dealing with timing of replacement on an asset. A firm might be having an asset which is a must for its operations and requires to be replaced frequently. Otherwise , the repair and maintenance cost will be to high or the normal operation will be unnecessarily affected. For example, a cold drink bottling plant supplies the product to the shopkeepers through specially designed and fabricated delivery vans or a firm manufacturing consumer durable e.g fridge etc. provides two wheelers to its service engineers who have to visit the customers for attending complaints. In these cases the delivery van or the two wheelers scooters must be replaced periodically otherwise (1)either the cost of maintenance will be too high or (2)the normal working will be hampered . Even before the periodical replacement. The cost of repairs and maintenance goes on increasing. So the question before the firm may be to decide whether to replace the asset only periodically or should it be replaced even earlier in view of the mounting maintenance cost. To put it differently the firm has to decide the optimum replacement timing. Example1 A delivery van must be replaced every four years and the related cash flows are as follows:
Figures in Rs'000 Age of Van in years Yr. 0 Yr. 1 1,5oo 400 800 Yr. 2 450 100 600 Yr. 3 500 200 400 Yr. 4 500 400 200

cost of van maintenance cost repairs scrap value

The firm is faced with the decision : should the van be kept for four years and then scrapped away for RS 2,00,000? Or should it be replaced earlier?

Solution: It may be noted that the van can be replaced after 1 year or 2 years or 3 years. So each replacement option will cover a different time period. The decision regarding optimum replacement timing can be taken on the basis of EAM. Since the cash flows are given in terms of cash outflows only i.e in terms of cost only, the decision can be taken on the basis of minimizing the EA of the cost. option 1- replacement cycle 4 years: if the firm decides to replace the van only at the end of 4th year, then the cost will be:
Figures in RS 000 years 0 1 2 3 4 Net flows 1,500 400 550 700 700 out PVF15%,n 1.000 0.870 0.756 0.658 0.572 Total PV Amount 1,500 348 416 461 400 3,125

Therefore the present value of cost is Rs 31,25,000. The EA of cost =PV of cost/ PVAF (15%, 4Y) =Rs 31,25,000/2.855 =Rs 10,94,571 So if the firm replaces the van after 4 years , it is meeting an annual cost of Rs 1o,94,571. OPTION II Replacement cycle 3 years: If the firm decides to replace the van at the end of 3rd year then the cost will be:

FIGURES IN RS OOO NET FLOW 1,500 400 550 300 OUT PVF15%,n 1.000 0.870 0.756 0.658 Total PV AMOUNT 1,500 348 416 197 2,461

YEAR 0 1 2 3

Therefore the present value of cost is Rs 24,61,000. The EA of cost = PV of cost/ PVAF (15%, 3Y) =Rs 24, 61, 000/2.283 = Rs 10,77,968. So if the firm replaces the van after every 3 years, it is meeting an annual cost of Rs 10,77968. OPTION III REPLACEMENT CYCLE 2 YEARS: If the firm decides to replace the van at the end of 2nd year then the cost will be:

YEAR 0 1 2

NET FLOW 1,500 400 50

OUT

FIGURES IN RS 000 PV PVF(15%,n) AMOUNT 1.000 1,500 0.870 348 0.756 38 TOTAL 1,810

Therefore the present value of cost is Rs 18,10,000. The EA of cost = PV of cost/ PVAF (15%, 2Y ) =Rs 18,10,000/1.626 =Rs 11,13,161 So if the firm replaces the van after every 2 years, it is meeting an annual cost of Rs 11,13, 161.

The firm is having a minimum of EA cost when the replacement cycle is 3 years. Therefore it is the most beneficial for the firm to replace the van every 3 years and not to wait till 4 years. The above procedure to find out the optimum replacement cycle is based upon two assumptions: 1) That the asset will be replaced indefinitely and it will be replaced by an identical asset with same cash flows. 2) Revenues (i.e cash inflows) are not affected by the age of the asset. However this is not a necessary assumption. If there is an expectations of decrease in revenues after some years then this decrease can also be taken as outflow of that year.