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# WOLLEGA UNIVERSITY

## SCHOOL OF GRADUATE STUDIES

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SCHOOL OF GRADUATE STUDIES
PROJECT PLANNING AND MANAGEMENT
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PROJECT PLANNING AND MANAGEMENT
(MBA 542)
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CHAPTER 6: ACCOUNTING FOR RISK AND
In chapter 5:
UNCERTAINTY
p
we have discussed the investment decision
criterion.
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The various criterions involve predicting values
for each of the various elements entering into the
definition of:
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definition of:
volume of output sold,
selling price,
i d i required investment,
labor costs per unit,
maintenance costs of machines
profit, and so forth.
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LEARNING OBJECTIVES?
1 To explain what factors may cause 1. To explain what factors may cause
deviations from the expected cash flows
of projects.
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2. To illustrate the applications of
switching value analysis in project
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evaluations
3. To demonstrate how sensitivity analysis
i f d i i l j is performed in practical project
evaluations.
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Projects are inevitably subject to a high degree of
WHY SENSITIVITY ANALYSIS
j y j g g
uncertainty and risk about what will actually
happen.
U t i t i th l lit f t t
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Uncertainty:- is the plurality of outcomes to
which objective probabilities cant be assigned.
No statistical probability can be attached to the
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No statistical probability can be attached to the
possible outcomes
Risk:- is the chance of occurrence of unexpected
l f diff i bl i i ld values of different variables: prices, yield, costs,
weather, and year of implementation.
It is a situation whereby known probabilities can It is a situation whereby known probabilities can
be attached to the outcomes
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SWITCHING VALUES AND SENSITIVITY ANALYSIS
A. Switching values
the value an element of a project would have to p j
reach as a result of a change in an unfavorable
direction before that project no longer meets the
minimum level of acceptability as indicated by
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minimum level of acceptability as indicated by
one of the measures of project worth.
we ask, by how much an element would have to
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change in an unfavorable direction before the
project would no longer meet the minimum
level of acceptability as indicated by one of the level of acceptability as indicated by one of the
measures of project worth.
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A. Switching values g
Example 1: Assume that 25% short
fall in net benefit yields an NPV of a e e e y e s a V o
11,985 Birr and 30% shortfall yields a
negative NPV of -10,000 Birr.
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g ,
Then, by how much percent can the net
benefit continuous falling before the
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benefit continuous falling before the
NPV of the project becomes negative?
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Switching values
U th i t l ti th d f IRR b Use the interpolation method of IRR above:
PVF
D D D
1
* ) (
PVF PVF
PVF
D D D
2 1
1
* ) (
1 2 1
+
+
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25 + 5{11,985 (11,985+10,000)}] = 27.726%.
This means, shortfalls in net benefits by
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more than 27.726 percent may result in zero
NPV.
Thi 27 726 t i th i f f t ! This 27.726 percent is the margin of safety!
Any decline by above 28 percent(rounded to
the nearest number) will make the project
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the nearest number) will make the project
unacceptable for the financial purpose.
Switching values
Example 2: Think of a hypothetical 1 hectare
Apple project having sum of present value of
benefits equal to Birr 31 278 04 and sum of benefits equal to Birr 31,278.04 and sum of
present value of costs equal to Birr 24,093.70. @

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Required?
1. By how much can cost rise before making the
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project unacceptable?
2. By how much can benefits fall before making
the projects unacceptable? the projects unacceptable?
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S i hi l Switching values
Solutions:
1. the Benefit Cost ration (B-C ratio) will
be 31,278.04/ 24,093.70 = 1.30.
ld i b 30% b f h C B
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costs could rise by 30% before the C -B
ratio becomes below 1, [(31,278.04
24 093 70)/ (24093 70)] X 100
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24,093.70)/ (24093.70)] X 100.
This means, 30 percent is the margin of
safety safety.
Any raise by above 30 percent may lead
the project to non-acceptability region. the project to non acceptability region.
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Switching values g
Solutions:
2. Benefits could fall by 23 percent before y p
the ratio is driven down to 1 [(31,278.04 -
24,093.70)/ (31,278.04)] X 100.
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Alternatively, taking the reciprocal of the
B - C ratio (1/1.3 = 0.77) and subtracting
it f 1 (1 0 77 0 23) 23 t
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it from 1, (1-0.77=0.23)= 23 percent.
In this case, the projects margin of safety
i 23 % is 23 %
Any fall by more than this number will
lead the project to unacceptable lead the project to unacceptable
condition!
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B. WHAT IS SENSITIVITY ANALYSIS?
How sensitive is the projects estimated financial
and economic benefits to:
Increase in costs?
Extension of implementation periods?
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Fall in prices?
Reworking analysis to see what happens under
these changed circumstances is sensitivity analysis.
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Sensitivity analysis asks the question is the project
sensitive to a drop in output price by a given
percent?
Computing switching values, on the other hand,
needs answering the question by how much can
prices increase to bring a change from acceptance to
rejection or vice versa.
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B. Sensitivity analysis
Sensitivity analysis essentially involves varying
key parameter values, usually one at a time.
if one particular element can be varied over a if one particular element can be varied over a
wide range of values without affecting the
decision:
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the decision is insensitive to uncertainties
regarding that particular element (more favorable
the element)
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the element).
if a small change in the estimate of one element
will alter the decision:
the decision is said to be very sensitive to changes
in the estimates of that element (unfavorable).
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B S iti it l i B. Sensitivity analysis
Example: A project has 20 years life. The
discount factor is 10%; investment cost is discount factor is 10%; investment cost is
Birr 10,000, salvage value is Birr 4,000,
annual output is 400 units per year, value
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annual output is 400 units per year, value
of output is 12 Birr /unit, and cost of
output is Birr 7 per unit.
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Required? Perform sensitivity analysis
under each of the following assumptions
l separately.
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B Sensitivity analysis B. Sensitivity analysis
f ? 1. What If salvage value is abandoned?
2. What if investment cost is doubled?
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3. What if selling price drop by 40
percent?
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p
4. What if variable cost per unit rise by
40 percent? 40 percent?
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Sensitivity analysis
Solutions:
1. Given the above values the NPV can be estimated as:
Cash inflows for the next 20 years will be = 400*12 = 4,800 Birr
Cash outflows for the next 20 years will be = 400*7 = 2,800 Birr.
Net cash flows from the operation will be = 2000 Birr.
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1. Apply Present values of Ordinary Annuity using
10% discount rate:
1
(

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.
) 1 (
1
1
(
(

=
)
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PVOAn
Birr 2 000 (8 51356) = Birr 17 027 Birr 2,000 (8.51356) = Birr 17,027.
2. In addition, we have present value of salvage converted
using 10% discount rate:
) 1 (
/
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n
FV Pv
+
=
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Birr 4,000 /(6.7275) = Birr 594.57.
Sensitivity analysis Sensitivity analysis
The total present value of the project
(from its operation and salvage values) (from its operation and salvage values)
would be
Birr 17,027 plus Birr 594.57 = 17,622 Birr.
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The net present value of the project would
be Birr 17,622-10,000 = Birr 7,622.
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1. If salvage value is abandoned, the NPV
would be:
NPV = 17,027 Birr-10,000 Birr = Birr 7,027
The project is insensitive to the change!
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Solutions
2. If the investment cost is doubled,
the NPV becomes
-2, 378 Birr (17,622-20,000).
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With this knowledge, the project
might be rejected, redesigned, or
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might be rejected, redesigned, or
accepted knowing that an
unfavorable result has a significant unfavorable result has a significant
chance of occurring.
The project is sensitive to the The project is sensitive to the
change!
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Solutions
3 if i d b 40 % 3. if price drop by 40 % ,
price would be 12-(12*.4) = 7.2 birr, and NPV will be:
Cash inflows for the next 20 years will be = Cash inflows for the next 20 years will be =
400*7.2 = 2,880 Birr
Cash outflows for the next 20 years will be =
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400*7 = 2,800 Birr.
Net cash flows from the operation will be = Birr,
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80.
The PVOA will be Birr 80 (8.51356) = Birr 681.1
Add the PV of the salvage value of = 594.57 Birr. Add the PV of the salvage value of 594.57 Birr.
Total PV of inflows = 1,275 Birr
Total investment cost of =10,000 Birr
NPV of inflows would be = -8,724 Birr
The project is sensitive to the price change!
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