Professional Documents
Culture Documents
Risk:
Quantifiable
Uncertainty:
Sensitivity of:
Initial Investment:
Sales Volume:
Variable costs:
Selling price:
Cost of capital:
IRR
Example 1
Example 2
Step 1
Year
PV of initial
investment
(7,000)
PV of variable
costs
PV of cash
inflows
(7000 * 1)
PV of net
cash flow
(7,000)
6,500 * 0.926
1
[2000 * 0.926]
[2,000 * 0.857]
(7,000)
(1,852)
6,019
4,167
6,500 * 0.857
(1,714)
5,571
3,857
(3,566)
11,590
1,024
Step 2
Cash flows
Formula
Initial
investment
Sales volume
Selling price
Variable costs
Cost of capital
Sensitivity
1,024/7,000 100% = 14.6%.
($1,024/$8,024) 100% = 12.8%
($1,024/$11,590) 100% = 8.8%.
($1,024/$3,566) 100% = 28.7%
The cost of capital can therefore
increase from 8% to over 18%
before the NPV becomes
negative
Weaknesses of
Sensitivity Analysis
1.
2.
3.
4.
Identifying risks
Risk matrix
Inherent risks
/risk factors
Promotion of concept
Design
Failure to meet
specified
standards
Professional
negligence
Contract negotiations,
Project approval,
Raising of capital,
Construction
Operation and
maintenance
Receiving revenues
Politi
cal
Business
Economic
Project
Natural
Financial
Crime
Decision
Scenario
Various
NPV
consequences
combinations
analysis
tree
NC
PO
Sa
NC
Risk
Nature:
Discrete
NC
Sa
PO
Sa
NC=
NPV
consequen
ces
PO=
PO
Occurrence
Scenario
Analysis
Decision
tree
Probability of
ds
o
th
Me
Risk Nature:
Continuous
computer
based
stochastic
modeling
1
Distribution of
possible NPVs
Many assumptions
Difficult to understand
Costs involved
SUMMARY
Project analysis
Decision
tree
Appraisal methods
Scenario analysis
Probability distribution
of NPVs
Stochastic
modeling
Transfe
r
Sales
Profitabil
ity
Etcs
Risk
mitigatio
ns
Avoi
d
NPVS
Costs
Accept /
Retentio
n
Redu
ce
Transfer:
To 3rd party
Avoid:
Terminate project
Reduction:
Undertake projects
Accept / retention:
Cannot be avoided/transfer
Residual risks
Fully identify
Analyse
Price inflation
Borrowing
Tax
Etcs
Causes of a shortage of
capital
Allocation of
capital available
most effectively.
Profitability index:
Capital rationing
Single period
Reasons:
5.
6.
7.
8.
9.
Profitability Index
PV of future cash flows (excluding capital investment)
PV of capital investment
Or,
NPV
Investment
Example 1
Suppose,
Decision?
Example 2 (divisible)
Example 2 (Nondivisible)
Example 2 (Nondivisible)
Problems of PI