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Se 307-Chapter 10 Sensitivity and Break-even Analysis

Se 307-Chapter 10 Sensitivity and Break-even Analysis

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Chapter 10

Sensitivity and Breakeven
Analysis


Handling Project Uncertainty
 Origin of Project Risk

 Methods of Describing
Project Risk

Origins of Project Risk
 Risk is to describe investment
project where cash flows are
not known in advance with
certainty. Project risk on the
other hand refer to variability
in a project’s PW. In essence,
we can see that risk is the
potential for loss.

 Risk Analysis is the
assignment of probabilities
to the various outcomes of
an investment project.
Origins of Project Risk continue….
 The decision to make a major capital investment such as introducing a
new product requires cash flow information over the life of a project.
 The profitability estimate of an investment depends on cash flow
estimations, which are generally uncertain.
 The factors to be estimated include
 the total market for the product;
 the market share that the firm can attain;
 the growth in the market;
 the cost of producing the product, including labor and materials;
 the selling price;
 the life of a product;
 the cost and the life of equipment needed; and
 the effective tax rates.
 Many of these factors are subject to uncertainty.
Methods of Describing Project Risk
Fist, begin analyzing project risk by determining the uncertainty inbuilt in a
project cash flows. We can do this analysis in a number of ways such as the
following;
Sensitivity Analysis (SA): Determines the effect on the PW of variations in the
input variables (revenues, operating cost, and salvage value). SA is sometimes
called “what if analysis” because it answers questions such as,
 What if incremental sales are only 1,000 units, rather than 2,00 units? Then
 what will be the NPW be?.
 SA begins with a base-case situation, which is developed using most-likely values
for each input. A useful way to present results of sensitivity analysis is to plot
sensitivity graphs.

Break-Even Analysis is a technique for studying the effect of variations in
output on a firm’s NPW.

Scenario Analysis is a technique that does consider the sensitivity of NPW to
both changes in key variables and to the range of likely variable values. The
decision maker may consider two extreme cases, a
 “worst-case” scenario (low unit sales, high variable cost per unit, high fixed cost,
and so on) and a
 “best-case” scenario to identify the extreme and most likely project outcomes.

Sensitivity Analysis – Example 10.1
 Transmission-Housing Project by Boston Metal Company
 New investment = $125,000
 Number of units = 2,000 units
 Unit Price = $50 per unit
 Unit variable cost = $15 per unit
 Fixed cost = $10,000/Yr
 Project Life = 5 years
 Salvage value = $40,000
 Income tax rate = 40%
 MARR = 15%

Example 10.1 - After-tax Cash Flow for BMC’s Transmission
Housings Project – “Base Case”
0 1 2 3 4 5
Revenues:
Unit Price 50 50 50 50 50
Demand (units) 2,000 2,000 2,000 2,000 2,000
Sales revenue $100,000 $100,000 $100,000 $100,000 $100,000
Expenses:
Unit variable cost $15 $15 $15 $15 $15
Variable cost 30,000 30,000 30,000 30,000 30,000
Fixed cost 10,000 10,000 10,000 10,000 10,000
Depreciation 17,863 30,613 21,863 15,613 5,581
Taxable Income $42,137 $29,387 $38,137 $44,387 $54,419
Income taxes (40%) 16,855 11,755 15,255 17,755 21,768
Net Income $25,282 $17,632 $22,882 $26,632 $32,651
8
Depreciation Calculation
– Cost Base = $125,000
– Recovery Period = 7-year MACRS

N
MACRS
Rate
Depreciation
Amount
Allowed Depreciation
Amount
1 14.29 % $17,863 $17,863
2 24.49 % $30,613 $30,613
3 17.49 % $21,863 $21,863
4 12.49 % $15,613 $15,613
5 8.93 % $11,150 $ 5,581
6 8.92 % $11,150 0
7 8.93 % $11,150 0
8 4.46 % $5,575 0
9
Gains (Losses) associated with Asset Disposal
• Salvage value = $40,000
• Book Value (year 5) = Cost Base – Total Depreciation
= $125,000 - $ 91,533
= $ 33,467
• Taxable gains = Salvage Value – Book Value
= $40,000 - $ 33,467
= $6,533
• Gains taxes = (Taxable Gains) (Tax Rate)
= $6,533 x (0.40)
= $2,613
Cash Flow Statement 0 1 2 3 4 5
Operating activities
Net income 25,282 17,632 22,882 26,632 32,651
Depreciation 17,863 30,613 21,863 15,613 5,581
Investment activities
Investment (125,000)
Salvage 40,000
Gains tax (2,613)
Net cash flow ($125,500) $43,145 $48,245 $44,745 $42,245 $75,619
(Example 10.1, Continued)
Example 10.1 BMC's Transmission-Housings Project
Income Statement
0 1 2 3 4 5
Revenues:
Unit Price 50 $ 50 $ 50 $ 50 $ 50 $
Demand (units) 2000 2000 2000 2000 2000
Sales Revenue 100,000 $ 100,000 $ 100,000 $ 100,000 $ 100,000 $
Expenses:
Unit Variable Cost 15 $ 15 $ 15 $ 15 $ 15 $
Variable Cost 30,000 30,000 30,000 30,000 30,000
Fixed Cost 10,000 10,000 10,000 10,000 10,000
Depreciation 17,863 30,613 21,863 15,613 5,581
Taxable Income 42,137 $ 29,387 $ 38,137 $ 44,387 $ 54,419 $
Income Taxes (40%) 16,855 11,755 15,255 17,755 21,768
Net Income 25,282 $ 17,632 $ 22,882 $ 26,632 $ 32,651 $
Cash Flow Statement
Operating Activities:
Net Income 25,282 17,632 22,882 26,632 32,651
Depreciation 17,863 30,613 21,863 15,613 5,581
Investment Activities:
Investment (125,000)
Salvage 40,000
Gains Tax (2,613)
Net Cash Flow (125,000) $ 43,145 $ 48,245 $ 44,745 $ 42,245 $ 75,619 $
12
 Is this investment justifiable at a
MARR of 15%?

 PW(15%) = -$125,000 +
+$43,145(P/F, 15%, 1) + . . . .
+$75,619(P/F, 15%, 5)
= $40,169 > 0

 Yes, Accept the Project

0
1 2 3 4 5
$125,000
$43,145
$48,245
$44,745
$42,245
$75,619
Years
Example 10.2 - Sensitivity Analysis for Five Key
Input Variables
Deviation -20% -15% -10% -5% 0% 5% 10% 15% 20%
Unit price $57 $9,999 $20,055 $30,111 $40,169 $50,225 $60,281 $70,337 $80,393
Demand 12,010 19,049 26,088 33,130 40,169 47,208 54,247 61,286 68,325
Variable
cost
52,236 49,219 46,202 43,186 40,169 37,152 34,135 31,118 28,101
Fixed cost 44,191 43,185 42,179 41,175 40,169 39,163 38,157 37,151 36,145
Salvage
value
37,782 38,378 38,974 39,573 40,169 40,765 41,361 41,957 42,553
Base
Sensitivity graph – BMC’s transmission-housings project
(Example 10.2)
-20%
-15% -10% -5%
0% 5% 10% 15% 20%
$100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
-10,000
Base
Unit Price
Demand
Salvage value
Fixed cost
Variable cost
Analytical Approach Unknown Sales
Units (X)
0 1 2 3 4 5
Cash Inflows:
Net salvage
37,389
X(1-0.4)($50)
30X 30X 30X 30X 30X
0.4 (dep)
7,145 12,245 8,745 6,245 2,230
Cash outflows:
Investment
-125,000
-X(1-0.4)($15)
-9X -9X -9X -9X -9X
-(0.6)($10,000)
-6,000 -6,000 -6,000 -6,000 -6,000
Net Cash Flow
-125,000 21X +
1,145
21X +
6,245
21X +
2,745
21X +
245
21X +
33,617
 PW of cash inflows

PW(15%)
Inflow
= (PW of after-tax net revenue)
+ (PW of net salvage value)
+ (PW of tax savings from depreciation

= 30X(P/A, 15%, 5) + $37,389(P/F, 15%, 5)
+ $7,145(P/F, 15%,1) + $12,245(P/F, 15%, 2)
+ $8,745(P/F, 15%, 3) + $6,245(P/F, 15%, 4)
+ $2,230(P/F, 15%,5)

= 30X(P/A, 15%, 5) + $44,490

= 100.5650X + $44,490

 PW of cash outflows:
PW(15%)
Outflow
= (PW of capital expenditure)
+ (PW) of after-tax expenses
= $125,000 + (9X+$6,000)(P/A, 15%, 5)
= 30.1694X + $145,113

 The NPW:
PW (15%) = 100.5650X + $44,490
- (30.1694X + $145,113)
= 70.3956X - $100,623.

 Breakeven volume:

PW (15%) = 70.3956X - $100,623 = 0
X
b
= 1,430 units.

Demand
PW of
inflow
PW of
Outflow

NPW
X 100.5650X
- $44,490
30.1694X
+ $145,113
70.3956X
-$100,623
0 $44,490 $145,113 100,623
500 94,773 160,198 65,425
1000 145,055 175,282 30,227
1429 188,197 188,225 28
1430 188,298 188,255 43
1500 195,338 190,367 4,970
2000 245,620 205,452 40,168
2500 295,903 220,537 75,366
Outflow
Break-Even Analysis Chart
0 300 600 900 1200 1500 1800 2100 2400
$350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
-50,000
-100,000
Profit
Loss
Break-even Volume
X
b

=

1
4
3
0

Annual Sales Units (X)
P
W

(
1
5
%
)

Scenario Analysis
Variable
Considered
Worst-
Case
Scenario
Most-Likely-
Case
Scenario
Best-Case
Scenario
Unit demand 1,600 2,000 2,400
Unit price ($) 48 50 53
Variable cost ($) 17 15 12
Fixed Cost ($) 11,000 10,000 8,000
Salvage value ($) 30,000 40,000 50,000
PW (15%) -$5,856 $40,169 $104,295

Handling Project Uncertainty

Origin of Project Risk
Methods of Describing Project Risk

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