Sensitivity Technique

13th October 2021 1 By indiafreenotes

Sensitivity analysis helps a business estimate what will happen to the project if the assumptions and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or estimates in a calculation to see the impact on the project’s finances. In this way, it prepares the business’s managers in case the project doesn’t generate the expected results, so they can better analyze the project before making an investment.

When cash inflows are sensitive under different circumstances more than one forecast of the future cash inflows may be made. These inflows may be regarded on ‘Optimistic’, ‘most likely’ and ‘pessimistic’. Further cash inflows may be discounted to find out the net present values under these three different situations. If the net present values under the three situations differ widely it implies that there is a great risk in the project and the investor’s is decision to accept or reject a project will depend upon his risk bearing activities.

Example

Mr. Aap is considering two mutually exclusive project ‘X’ and ‘Y’. You are required to advise him about the acceptability of the projects from the following information.

Project X Rs. Projects Y Rs.
Cost of the investment 1,0,0000 1,00,000
Forecast cash inflows per annum for 5 years
Optimistic 60,000 55,000
Most likely 35,000 30,000
Pessimistic 20,000 20,000

(The cut-off rate may be assumed to be 15%).

Solution

Calculation of net present value of cash inflows at a discount rate of 15%. (Annuity of Re. 1 for 5 years).

For Project X

Event Annual cash Inflow Rs. Discount factor @ 15 % Present value Rs. Net Present value Rs.
Optimistic 60,000 3.3522 2,01,132 1,01,132
Most likely 35,000 3.3522 1,17,327 17,327
Pessimistic 20,000 3.3522 67,105 (32,895)

For Project Y

Event Annual cash Inflow Rs. Discount factor @ 15 % Present value Rs. Net Present value Rs.
Optimistic 55,000 3.3522 1,84,371 84,371
Most likely 30,000 3.3522 1,00,566 566
Pessimistic 20,000 3.3522 67,105 (32,895)

The net present values on calculated above indicate that project Y is riskier as compared to project X. But at the same time during favourable condition, it is more profitable also. The acceptability of the project will depend upon Mr. Selva’s attitude towards risk. If he could afford to take higher risk, project Y may be more profitable.