# June 2009 question Q1 part a – sensitivity analysis

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• Anonymous
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Hi John:

The requirement for June 2009 question 1 asks for a sensitivity analysis of 1m change in initial investment. The solution is absolutely bizzare. I have no idea how they have arrived to those answers. Could you briefly explain how it is done?

Thanks!

SK

John Moffat
Keymaster
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The point is that if they spend an extra 1m on the investment, then all the cash flows (apart obviously the extra 1m) would stay exactly as before, except that the capital allowances would greater (and therefore the tax saving on the capital allowances).
What you need to do is calculate the additional capital allowances there would be each year on another 1M, then calculate the extra tax saving there would be on the extra allowances, and then the present value of the tax savings. That PV, less the 1M extra investment at time 0, will be the change there will be in the exisiting NPV.

Hope that helps.

dazhong0703
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What are the different functionalities between sensitivity and simulation analysis in improving the accuracy of NPV? Thank you.

John Moffat
Keymaster
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What do you mean by functionalities?

Neither sensitivity nor simulation improve the accuracy.

Sensitivity gives an indication as to how important the various estimates are. If one has a low sensitivity then only a small error in the estimate would mean we have made the wrong decision. Therefore we would do a lot more work trying to get as accurate an estimate as possible, or maybe decide not to take the risk of doing the project.

Simulation looks at all possible NPV’s that could result, and then we are able to estimate the probability of the NPV ending up positive, and therefore the probability of our decision to accept (or reject) being the correct decision.

dazhong0703
Participant
• Topics: 44
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What I mean is when I check past paper suggested ans for testing sensitivity or simulation, they always put in ‘other factors’ as one point. I just want to reproduce, but firstly I must understand what sensitivity or simulation analysis can improve. Especially for simulation, what probability, distribution, random variables, etc. very hard to understand. Could you elaborate some more within one or two paragraghs, pls? Thank you.

E.g.
Other factors
(i) Sandro Hotel inc should consider the accuracy of the cash flow projections, sales, costs, tax rate the realisable value of the asset. Sensitivity analysis or simulation analysis might be used to investigate the effect of changes in key cash flows.
(ii) The discount rate used was calculated on the assumption that Angus business risk will be the same as the business risk that Sandro will face in the theme park sector. This might not necessary be true.
(iii) No consideration is taken of the cash flows beyond the company’s four year planning horizon.
……

John Moffat
Keymaster
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Sensitivity is a measure of the change that can be ‘afforded’ before we would reject the project. So, for example, if the sensitivity of a certain factor was 50% it would mean it would have to change by 50% before we would reject the project – I would not be too worried because although my estimate might be wrong it would be unlikely to be so much wrong! However, if the sensitivity was 5% then I would be a lot more worried because it would mean that if my estimate was only 5% wrong then we should be rejecting the project.

Simulation looks at all the possible results that there could be. Maybe we have estimated sales volume as 10,000 units per year, but it could be 5,000 or it could be 15,000. In addition we might have estimated that the selling price will be \$10 per unit, but it might be \$11 and it might be \$9.

If we can list all the possible things that can happen and if we know the probabilities of them happening, then we could set up a spreadsheet and list every possible result and calculate the probabilities of those results. We could therefore calculate the probability of getting a positive NPV.

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