Sensitivity Analysis

Sensitivity Analysis CA Sangeeta Pandit HOD Finance SIMSREE

Risk Analysis • Risk and Business Decisions • Capital Budgeting Decisions • Expository convenience –risk of existing & new investments-sameaverage cost of capital • Risks differ-R & D, expansion, replacement

Evaluation of Investments • Financial Analysts evaluate projects in 2 phases • 1. Calculate NPV, IRR….. • 2. Risk Analysis • Risk Analysis techniques are very precise but they rely on information that is subjective

Techniques of Risk Analysis Two Categories • (1) Stand-Alone Risk • (2) Risk in context of Firm or Market

Different Techniques Technique s Scenario Analysis Contextu al

Stand -Alone

Sensitivity Analysis

Scenario Analysis

Break-even Analysis

Hillier Model

Simulation Analysis

Decision Tree Analysis

Corp.Ris k Analysis

Market Risk Analysi s

• Sensitivity Analysis: How sensitive is your finding of NPV, IRR ….. to a change in one of the variables, like sales, expenditure….. • Scenario Analysis: How sensitive is your finding of NPV, IRR ….. to a change in more variables, typically-the 3 scenarios are considered-exp.opt.pessim • Break-Even-Financial Break even • Hilliers Model: Mathematical model

• Simulation : Computer aidedsoftwares-exogenous variables, stochastic in nature) • Decision tree: start from the left & starts branching off

Sources of Risk • • • • •

Project Risk Competitive Industry-specific Market risk International Risk

Measures of Risk • • • •

Range Standard Deviation Coefficient of variation Semi-variance

Example NPV

Probability

200

.3

600

.5

900

.2

Calculation of • • • • • • • • • • •

(Probability Weighted NPV) Expected Value .3*200+.5*600+.2*900=540 1.Range is 900-200=700 2.Standard deviation ( σ “sigma”) = square root of: .3*(200-540)2+.5(600-540)2 +.2(900-540)2 = 62400 sq.root=249.8 3. Variance= (σ²)= 62400 4. Co-efficient of variation=CV= σ /Expected Value =249.8/540=.46 Semi-Variance (only negative outcomes considered) = .3(200-540)2 = 34680 Semi-standard deviation=sq. root of variance=186.2

Sensitivity Analysis is What if ? • Tries to understand what will happen to the viabilty of a project if some variable like sales/raw material cost/etc. deviates from its expected value

Example • A firm is contemplating investment of Rs.20000 in a project of 10 yrs. It is estimated that annual: Sales-Rs.18,000. Variable exp-Rs.12000(66.67%), Fixed Costs-Rs.1000, Depreciation would be 10% (SLM), Tax @ 33.33% & cost of capital is 12%. (PV factor-5.650) • NPV=-20,000+4000*5.650=2600 • 2nd stage to analyse risk by sensitivity analysis

Sensitivity to NPV due to change in variable • Fig are in ‘000

Exercise • A project of 2 yrs costing Rs.7000 has cash outflows of Rs.2000 & Rs.2500 in year 1 & year 2 resp. It will result in savings of Rs.6000 & Rs.7000 in year 1 & 2 resp. If cost of capital is 8% measure the sensitivity of the three variables to NPV becoming zero