project note

7/29/2019 project note

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WOLLEGAUNIVERSITY @A

MASTERS OF BUSINESS ADMINISTRATION

massut

(MBA 542)

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CHAPTER 6: ACCOUNTING FOR RISK AND

In cha ter 5:

UNCERTAINTY

we have discussed the investment decisioncriterion.

@Adm

The various criterions involve predicting values

for each of the various elements entering into the

definition of:

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volume of output sold,

selling price,

require investment, labor costs per unit,

maintenance costs of machines

profit, and so forth.2


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LEARNING OBJECTIVES?

.

deviations from the expected cash flowsof projects.

@Adm

2. To illustrate the applications of

switching value analysis in project

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evaluations

3. To demonstrate how sensitivity analysis

s per orme n pract ca pro ectevaluations.

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Pro ects are inevitabl sub ect to a hi h de ree of

WHY SENSITIVITY ANALYSIS

uncertainty and risk about what will actuallyhappen.

@Adm

ncer a n y:- s e p ura y o ou comes o

which objective probabilities cant be assigned.

No statistical robabilit can e attached to the

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possible outcomes

Risk:- is the chance of occurrence of unexpected

va ues o i erent varia es: prices, yie , costs,weather, and year of implementation.

be attached to the outcomes4


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SWITCHING VALUES AND SENSITIVITY ANALYSISA. Switching values

the value an element of a ro ect would have to

reach as a result of a change in an unfavorabledirection before that project no longer meets the

@Adm

one of the measures of project worth.

we ask, by how much an element would have to

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change in an unfavorable direction before the

project would no longer meet the minimum

measures of project worth.

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A. Switching valuesExample 1: Assume that 25% short

fall in net benefit ields an NPV of

11,985 Birr and 30% shortfall yields ane ative NPV of -10 000 Birr.

@Adm

Then, by how much percent can the net

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NPV of the project becomes negative?

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Switching values

se e n erpo a on me o o a ove:

PVFPVF 21121

@Adm

25 + 5{11,985 (11,985+10,000)}] = 27.726%.

This means, shortfalls in net benefits by

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more than 27.726 percent may result in zero

NPV.

s . percen s e marg n o sa e y Any decline by above 28 percent(rounded to

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unacceptable for the financial purpose.


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Switching values Example 2: Think of a hypothetical 1 hectare

Apple project having sum of present value of

, .

present value of costs equal to Birr 24,093.70. @Adm

Required?

1. By how much can cost rise before making the

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pro ect unaccepta e

2. By how much can benefits fall before making

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Switching values

Solutions:

1.

the Benefit Cost ration (B-C ratio) willbe 31,278.04/ 24,093.70 = 1.30.@Adm

costs cou r se y e ore t e -

ratio becomes below 1, [(31,278.04

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, . . .

This means, 30 percent is the margin of

.

Any raise by above 30 percent may lead

the ro ect to non-acce tabilit re ion.9


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Switchin valuesSolutions:

2. Benefits could fall b 23 ercent before

the ratio is driven down to 1 [(31,278.04 -24,093.70)/ (31,278.04)] X 100.

@Adm

Alternatively, taking the reciprocal of the

B - C ratio (1/1.3 = 0.77) and subtracting

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t rom , - . = . = percent.

In this case, the projects margin of safety

s Any fall by more than this number will

condition!

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11/19

B. WHAT IS SENSITIVITY ANALYSIS?

How sensitive is the projects estimated financialand economic benefits to: Increase in costs?

Extension of implementation periods?

@Adm

Fall in prices?

Reworking analysis to see what happens under

these changed circumstances is sensitivity analysis.

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Sensitivity analysis asks the question is the projectsensitive to a drop in output price by a givenpercent?

Computing switching values, on the other hand,needs answering the question by how much canprices increase to bring a change from acceptance torejection or vice versa. 11


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B. Sensitivity analysis

Sensitivity analysis essentially involves varying

key parameter values, usually one at a time.

wide range of values without affecting thedecision:

@Adm

the decision is insensitive to uncertainties

regarding that particular element (more favorable

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.

if a small change in the estimate of one element

will alter the decision:

the decision is said to be very sensitive to changesin the estimates of that element (unfavorable).

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. ens v y ana ys s

Example: A project has 20 years life. The

Birr 10,000, salvage value is Birr 4,000,annual out ut is 400 units er ear value

@Adm

of output is 12 Birr /unit, and cost of

output is Birr 7 per unit.

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Required? Perform sensitivity analysis

under each of the following assumptions

separate y.

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.

1.

What If salvage value is abandoned?2. What if investment cost is doubled?

@Adm

3. What if selling price drop by 40

ercent?

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4. What if variable cost per unit rise by

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Sensitivity analysis

Solutions:

1. Given the above values the NPV can be estimated as:

Cash inflows for the next 20 years will be = 400*12 = 4,800 Birr

Cash outflows for the next 20 years will be = 400*7 = 2,800 Birr.

Net cash flows from the o eration will be = 2000 Birr.

@Adm

1. Apply Present values of Ordinary Annuity using

10% discount rate:

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.)1(

1

r

rn

APVOAn

=, . , .

2. In addition, we have present value of salvage converted

using 10% discount rate:)1(/ r

n

FVPv 15

Birr 4,000 /(6.7275) = Birr 594.57.


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The total present value of the project

would be Birr 17 027 lus Birr 594.57 = 17 622 Birr.

@Adm

The net present value of the project would

be Birr 17,622-10,000 = Birr 7,622.

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1. If salvage value is abandoned, the NPV

would be:

NPV = 17,027 Birr-10,000 Birr = Birr 7,027 The project is insensitive to the change!

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Solutions

2. If the investment cost is doubled,

the NPV becomes -2 378 Birr 17 622-20 000 .

@Adm

With this knowledge, the project

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accepted knowing that an

chance of occurring.

change!

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Solutions

. pr ce rop y ,

price would be 12-(12*.4) = 7.2 birr, and NPV will be:

400*7.2 = 2,880 BirrCash outflows for the next 20 years will be =

@Adm

400*7 = 2,800 Birr.

Net cash flows from the operation will be = Birr,

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.

The PVOA will be Birr 80 (8.51356) = Birr 681.1

Add the PV of the salva e value of = 594.57 Birr.

Total PV of inflows = 1,275 Birr

Total investment cost of =10,000 Birr

NPV of inflows would be = -8,724 Birr

The project is sensitive to the price change!

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@Adm

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