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SCHOOL OF GRADUATE STUDIES

MASTERS OF BUSINESS ADMINISTRATION

PROJECT PLANNING AND MANAGEMENT

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PROJECT PLANNING AND MANAGEMENT

(MBA 542)

1

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.

2

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.

3

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

4

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.

5

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?

6

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

7

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

j t t bl ?

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project unacceptable?

2. By how much can benefits fall before making

the projects unacceptable? the projects unacceptable?

8

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.

9

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!

10

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.

11

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).

12

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

(

a

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t

.

) 1 (

1

1

(

(

=

)

`

+

r

r

n

A

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 (

/

r

n

FV Pv

+

=

15

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!

16

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!

17

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,

80

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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!

18

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19

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