Something that worries me is that I understood the whole lecture but I got parts iv and v wrong because in both cases I divided the NPV by the fixed costs (15,000) in part iv and by the scrap value (15,000) in part v and consequently got the wrong answer.

But my understanding was that I wanted to know the percentage change in fixed costs or scrap value because that would ultimately bring the present value of that particular flow down by the same percentage resulting in a NPV of zero and that’s what we are doing, aren’t we. Where am I wrong then?

For the NPV to end up at zero, the PV of the relevant flow has to change by the amount of the current NPV.

So, for example, if the NPV is 100, and the PV of the fixed costs is 1,000. Then for the NPV to fall by 100 to zero, the PV of the fixed costs will have to increase by 100.
In percentage terms this is 100/100 = 10%
It is always the NPV divided by the PV of the flows that change (expressed as a %).

It should be clear that it would be silly to divide a % by a PV. For cost of capital we have to go back to the basis logic and divide the change needed (0.84) by the current value (15)

Hi John, permit me ask you this question. how do you go about calculating the sensitivity of the price. I mean the percentage of the price change that will lead to the NPV falling to zero
thank you

For this particular example we can not, because we do not know the estimated selling price.
In general terms you would take the same approach as the others i.e. express the NPV as a % of the present value of those cash flows that would change (which in the same of the price would be the sales revenue flows).

you mean NPV/ present value of sales revenue? this will give me the percentage change in sales revenue. I am preparing for P4 and there is this question Dec 2012 question that asked for this. when i tried going through the solution i didnt understand how it was solved. If use this your approach i will get the percentage change in sales revenue but the question asked for sales price

But surely, if the sales price changes by 10% then the revenue changes by 10% as well!
(I know it could be affected by other things, but with sensitivity we can only consider one item at a time)

One other thing is that if there is tax in the question, then the flows that will change if the selling price changes will be the revenue and the tax on the revenue. So you need the net PV of these two. Then express the NPV of the project as a % of it.

Thanks John,
an issue here,when we are calculating the sensitivity of change on for example part (iii) which is contribution p.u, why do we put that negative sign yet in our table the final value was a positive??

Now the F9 carries a MCQ do I need to read the text book from cover to cover, or your notes, lectures and the kit will be sufficient to help me pass the exam.

Hello Sir,
why lower the sensitivity—> the more worried about item.? how about the higher sensitivity, is the higher sensitivity more optimal? could u plz explain it again. thanks

Its not really a question of calling it the optimum.

The problem is that we are making a decision on forecasts of cash flows, and therefore the actual cash flows may turn out to be different – if they are different then the NPV might turn out to be negative and then we will have made the wrong decision.

The higher the sensitivity the less the chance is of that flow changing enough to affect the decision. However if the sensitivity is low, then it means that even just a small change in the flow will affect the decision. Therefore the lower the sensitivity the more risk we are taking and therefore the more we will try to estimate the flow accurately (or else maybe decide not to take the risk).

Arun says

Hi John,

Something that worries me is that I understood the whole lecture but I got parts iv and v wrong because in both cases I divided the NPV by the fixed costs (15,000) in part iv and by the scrap value (15,000) in part v and consequently got the wrong answer.

But my understanding was that I wanted to know the percentage change in fixed costs or scrap value because that would ultimately bring the present value of that particular flow down by the same percentage resulting in a NPV of zero and that’s what we are doing, aren’t we. Where am I wrong then?

Thanks in advance!

John Moffat says

For the NPV to end up at zero, the PV of the relevant flow has to change by the amount of the current NPV.

So, for example, if the NPV is 100, and the PV of the fixed costs is 1,000. Then for the NPV to fall by 100 to zero, the PV of the fixed costs will have to increase by 100.

In percentage terms this is 100/100 = 10%

It is always the NPV divided by the PV of the flows that change (expressed as a %).

Kelvin says

Mr John nice to know you

I greatly need your help on sensitivity analysis

It on the fact that how to calculate sensitivity of selling price

John Moffat says

You take exactly the same approach as for the others.

Calculate the present value of the revenue flows (because they are the flows that will change if the selling price changes).

The sensitivity is then the NPV as a percentage of the PV just calculated.

aliimranacca007 says

Dear sir in example in solution for senstivity of cost of capital

by using IRR rate 15.84% and given rate is 15%

in calculation of senstivity of cost of capital you do.

0.84÷15 why you do like this bcoz by formola as you told it will be NPV ÷ pv of variables

John Moffat says

It should be clear that it would be silly to divide a % by a PV. For cost of capital we have to go back to the basis logic and divide the change needed (0.84) by the current value (15)

questforknowledge says

thank you sir John

questforknowledge says

Hi John, permit me ask you this question. how do you go about calculating the sensitivity of the price. I mean the percentage of the price change that will lead to the NPV falling to zero

thank you

John Moffat says

For this particular example we can not, because we do not know the estimated selling price.

In general terms you would take the same approach as the others i.e. express the NPV as a % of the present value of those cash flows that would change (which in the same of the price would be the sales revenue flows).

questforknowledge says

you mean NPV/ present value of sales revenue? this will give me the percentage change in sales revenue. I am preparing for P4 and there is this question Dec 2012 question that asked for this. when i tried going through the solution i didnt understand how it was solved. If use this your approach i will get the percentage change in sales revenue but the question asked for sales price

John Moffat says

But surely, if the sales price changes by 10% then the revenue changes by 10% as well!

(I know it could be affected by other things, but with sensitivity we can only consider one item at a time)

One other thing is that if there is tax in the question, then the flows that will change if the selling price changes will be the revenue and the tax on the revenue. So you need the net PV of these two. Then express the NPV of the project as a % of it.

brenda1 says

Thanks John,

an issue here,when we are calculating the sensitivity of change on for example part (iii) which is contribution p.u, why do we put that negative sign yet in our table the final value was a positive??

John Moffat says

To show that we are only worried about the contribution falling. (If the contribution increased then there would be no problem at all)

cartea says

Now the F9 carries a MCQ do I need to read the text book from cover to cover, or your notes, lectures and the kit will be sufficient to help me pass the exam.

John Moffat says

Our notes and lectures (together with lots of practice using a Revision Kit) are enough to be able to pass the exam.

cartea says

Thank you very much. I understand your lectures more than the text book and and my lecturer. I hope you keep on lecturing we need you.

arman90fy says

Hello Sir,

why lower the sensitivity—> the more worried about item.? how about the higher sensitivity, is the higher sensitivity more optimal? could u plz explain it again. thanks

John Moffat says

Its not really a question of calling it the optimum.

The problem is that we are making a decision on forecasts of cash flows, and therefore the actual cash flows may turn out to be different – if they are different then the NPV might turn out to be negative and then we will have made the wrong decision.

The higher the sensitivity the less the chance is of that flow changing enough to affect the decision. However if the sensitivity is low, then it means that even just a small change in the flow will affect the decision. Therefore the lower the sensitivity the more risk we are taking and therefore the more we will try to estimate the flow accurately (or else maybe decide not to take the risk).

arman90fy says

great explanation dear sir

thanks alot

izhar says

Sir if calculation of tax given then how we calculate present value of relevant cash flow ?

jay0v says

Thank you sir! 😀

jay0v says

Sir, will the requirements be given in exam asking us which sensitivity to calculate, the initial investment, sales volume, selling price, etc.?

John Moffat says

Yes certainly:-)

If the question wants the sensitivity then it will specify of what.