june 2007 Q.2(c)

what is the name of the question please?

I would rather classify the computation as a capital budgeting question because the core technique is NPV. The left cycle budget is merely to provide a scenario for analysis and discussion.

Applying sensitivity analysis to capital budgeting in an examination setting is getting popular because sensitivity analysis is to evaluate the impact of risk factors. Further, sensitivity analysis could be tested also in P1 and P3.
Sensitivity analysis, essentially, is a ‘what-if’ analysis. The purpose is to discover the sensitivity of the result to the change of each risk factor, given other risk factors unchanged. For example, we have 3 risk factors, sales price, advertising cost, and interest rate. The profit will become 0 if the sales price decreases by 2% (i.e.-2%), given the other 2 risk factors unchanged. The profit will be zero also when the advertising cost increases by 1% (i.e. +1%), or the interest rate by 3% (i.e. +3%). The profit should be most sensitive to the advertising cost, then to the price, and least sensitive to the interest rate.

Applying it to NPV, the pivotal point of NPV is zero because it is the threshold to accept or reject a project. NPV is therefore the result. The generic risk factors in an NPV are positive change in initial outlay, annual cash outflows,and cost of capital, as well as the negative change in annual cash inflows, and investment time horizon. You should calculate the percentage change of each risk factor that will make the NPV become zero. For example, the initial outlay is $120. Now, you find that the NPV will become zero when the initial outlay is $140. The percentage change is ($140/$120) – 1 = 16.67%. In addition, the sensitivity of the NPV to the cost of capital is (IRR/Cost of capital) – 1. You can do the rest by applying the same logic.

Further, you have to know the limitation of sensitivity analysis. Rather than giving the answer, let you think on it first.

Thanks for the post above. How do you find out a what outlay figure will make the NPV equal to zero? – for example the $140 above – how is this derived?

Dear Sosologos, this was helpful. Thank you. Help me Dec 2004 Q4 ii posted on the Forum. Woods Ltd