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SENSITIVITY

ANALYSIS
An Assignment in Managerial
Economics I
Submitted By
Aliya Zubair
Ankan Langthasa
Avinash D.
Gurashish Singh
M. Venugopal Reddy
Parag Rastogi
In the evaluation of an investment project, we work with the forecasts of cash flows.
Forecasted cash flows depend on the expected revenue and costs. Further, expected revenue
is a function of sales volume and unit selling price. Similarly, sales volume will depend on
market size and the firm’s market share. Costs include variable costs, which depend on sales
volume, and unit variable costs and fixed costs. The net present value or the internal rate of
return of the project is determined by analysing the after-tax cash flows arrived at by
combining forecasts of various variables. The reliability of NPV or IRR of the project will
depend on the reliability of the variables underlying the estimates of net cash flows. To
determine the project’s NPV or IRR, we can work out how much difference it makes if any of
these forecasts goes wrong. We can change each of the forecasts, over time, to at least three
values: pessimistic, expected and optimistic. The NPV of the project is recalculated under
these different assumptions. This method of recalculating the NPV or IRR, by changing each
forecast is called sensitivity analysis.

Sensitivity analysis is a way of analysing change in the project’s NPV (or IRR) for a given
change in one of the variables. It indicates how sensitive a project’s NPV (or IRR) is to
changes in particular variables. The more sensitive the NPV, the more critical is the variable.
The following three steps are involved in the use of sensitivity analysis:

• Identification of all those variables, which have an influence on the project’s NPV (or
IRR)

• Definition of the underlying (mathematical) relationship between the variables

• Analysis of the impact of the change in each of the variables on the project’s NPV

The decision maker, while performing sensitivity analysis, computes the project’s NPV (or
IRR) for each forecast under three assumptions: pessimistic, expected and optimistic. It
allows him/her to ask “what if” questions. For example, what (is the NPV) if the volume
increases or decreases? What (is the NPV) if the variable or the fixed costs increases or
decreases? What (is the NPV) if the selling price increases or decreases? What (is the NPV) if
the project’s life is more or less than anticipated? A whole range of questions can be
answered with the help of sensitivity analysis. It examines the sensitivity of the variables
underlying the computation of the NPV or IRR, rather than attempting to quantify risk. It can
be applied to any variable, which is an input for the after-tax cash flows. Before proceeding
to sensitivity analysis, it is necessary to have knowledge about some terms
Risk and uncertainty

Risk is referred to a situation where the probability distribution of the cash flows of an
investment proposal is known.

Uncertainty is different from risk in sense because here no information is available to
formulate a probability distribution of the cash flows.

When a project is taken up some kind of risk is always attached with it. This kind of risk
could be because of the inability of the decision maker to make perfect forecast. Forecasts
cannot be made with perfection or certainty since the future events on which they depend are
uncertain.

Even if the risk in project is diversifiable, one still need to know why the venture could fail.
Once it is known, it becomes easy to decide whether the project is worth investing or not? An
investment is not risky if one can specify a unique sequence of cash flows for it. But the
whole problem is that cash flows cannot be forecast accurately, and alternative sequences of
cash flows can occur depending on the future events. Thus, risk arises in investment
evaluation because on cannot anticipate the occurrence of the possible future events with
certainty and consequently, cannot make any correct prediction about the cash flow sequence.

Net Present Value

Net present value (NPV) or net present worth (NPW) is defined as the total present value
(PV) of a time series of cash flows. It is a standard method for using the time value of money
to appraise long-term projects. Used for capital budgeting, and widely throughout economics,
it measures the excess or shortfall of cash flows, in present value terms, once financing
charges are met.

NPV is an indicator of how much value an investment or project adds to the value of the firm.
With a particular project, if it is a positive value, the project is in the status of discounted cash
inflow. If it is a negative value, the project is in the status of discounted cash outflow.
Appropriately, risked projects with a positive NPV could be accepted. This does not
necessarily mean that they should be undertaken since NPV at the cost of capital may not
account for opportunity cost, i.e. comparison with other available investments. In financial
theory, if there is a choice between two mutually exclusive alternatives, the one yielding the
higher NPV should be selected. It is give by the formula:
NPV= PVB - PVC

Internal Rate of Return

The internal rate of return (IRR) is a capital budgeting metric used by firms to decide whether
they should make investments. It is an indicator of the efficiency or quality of an investment,
as opposed to net present value (NPV), which indicates value or magnitude.

The IRR is the annualized effective compounded return rate which can be earned on the
invested capital, i.e., the yield on the investment.

A project is a good investment proposition if its IRR is greater than the rate of return that
could be earned by alternate investments (investing in other projects, buying bonds, even
putting the money in a bank account). Thus, the IRR should be compared to any alternate
costs of capital including an appropriate risk premium. In general, if the IRR is greater than
the project's cost of capital, or hurdle rate, the project will add value for the company. In the
context of savings and loans the IRR is also called effective interest rate. It can be calculated
by the formula:

Lower The difference NPV at Lower Discount
Rate

Discount + between two The Absolute
difference between

Rate discount rates NPVs at HDR and LDR

(HDR-LDR)
Cost-benefit analysis

Cost-benefit analysis involves, whether explicitly or implicitly, weighing the total expected
costs against the total expected benefits of one or more actions in order to choose the best or
most profitable option. The process involves monetary value of initial and ongoing expenses
vs. expected return. Cost-benefit analysis is mainly, but not exclusively, used to assess the
value for money of very large private and public sector projects. This is because such projects
tend to include costs and benefits that are less amenable to being expressed in financial or
monetary terms (e.g. environmental damage), as well as those that can be expressed in
monetary terms. Private sector organisations tend to make much more use of other project
appraisal techniques, such as rate of return, where feasible.
The Benefit-Cost Ratio is given by the formula:

BCR = Present Worth of Benefits
Present Worth of Costs

MODEL PROJECT ON CULTIVATION OF OIL PALM

Technical aspects of oil palm :

Oil Palm (Elaeis guinensis Jacq.) is a native of Guinea Coast of West Africa. It belongs to
family Palmae and tribe Cocoineae. Oil palm is the highest oil producer among perennial oil
yielding crops. It produces two distinct oils viz., palm oil (extracted from meso carp of fresh
fruits) and palm kernel oil (from kernel). Palm oil has excellent health attributes. It is rich in
vitamins A and E and is cholesterol free. Palm oil can be used in formulation of margarine
and cooking fat such as vanaspathi. It can be used in manufacture of biscuits, ice creams,
soaps, detergents, and shampoos and also as frying fat. Palm kernel oil has variety of
industrial uses.

Financial aspects

Unit cost: The cost of cultivation of one hectare of oil palm works out to Rs. 74800 inclusive
of Rs. 25000 for installation of drip system of irrigation. The cost of cultivation was assessed
based on the discussions held with National Research Centre for Oil palm, Pedavegi,
Department of Horticulture, Krishna district and farmers. The above costs are average
indicative costs. Banks may adopt higher or lower than the average costs depending on local
conditions and viability of the units. The technical and financial parameters and the cost of
cultivation are given in Annexure I and II. The following aspects have been considered in
arriving at unit cost.

The cost of imported planting material is Rs. 55 and that of indigenous material is Rs. 50 per
seedling. The seedlings are supplied to farmers by the processing companies which generally
import from Costa Rica. Hence for calculation of unit cost price of Rs. 55 per seedling is
considered.

The expenditure towards manure and fertilizer is calculated on the basis of the fertilizer
schedule recommended by National Research Centre for oil palm, Pedavegi and the
prevailing prices of fertilizers.
For drip irrigation, cost of drip irrigation system for oil palm as a mono crop is considered

The expenditure towards inter crop is not provided for in the unit cost since the choice of
inter crop varies from farmer to farmer. Most of the farmers avail crop loan for the purpose.
Income from inter crop has not been taken into account in financial analysis.

Financial analysis: Financial analysis was carried out for one hectare of oil palm
cultivation. For financial analysis, the income was assessed on a conservative basis. The
productivity of a ten year old oil palm garden was considered at 18 ton per hectare against the
normal yield of 25 ton per hectare in Krishna district. The sale price was considered at Rs.
3500 per ton of FFB (Fresh Fruit Bunches) against the existing price of Rs. 4100 per ton of
FFB. The details of the financial analysis are shown as Annexures II and III. It may be
observed therefrom that cultivation of oil palm in one hectare is financially viable. The
major financial indicators are given below

NPV:Rs. 48104

BCR:1 : 1.49

IRR:25%

Price: The current price of Rs. 4100 per ton is done. However, considering the magnitude of
fluctuations in the prices, sensitivity analysis was attempted with 10% reduction in income
and 10% increase in costs. The financial indicators after the sensitivity analysis are as under:

NPV : Rs. 23704

BCR : 1 : 1.22

IRR : 20%

The investment is found viable even within the assumption of reduction in market
prices by 10%. The details of financial analysis are given in Annexure III
Annexure I

Technical and financial parameters

Technical

1 Spacing (m X m) 9X9
2 Plant population 143
3 Manure and fertilizer (kg/palm/year)
Year FYMUrea SSP MOP MgSO4
1 50 0.870 1.250 0.667 0.125
2 50 1.740 2.500 1.333 0.250
3 50 2.610 3.750 2.000 0.500
4 50 3.000 5.000 4.000 0.500

Yield (ton
Yield Year of
FFB/ha)
4 4
5 6
6 8
7 12
8 14
9 16
10 onwards 18

Financial

1 Planting material (Rs/seedling) 55
2 Manure and fertilizer (Rs/kg)
FYM 0.20
Urea 5.00
SSP 3.20
MOP 4.60
MgSO4 5.00
3 Labour wages (Rs/manday) 50
4 Sale price (Rs/ton of FFB) 3500
Annexure II

Cost of cultivation

5.1110 Item of expenditure Year Total
Units 1 2 3 4
I Material
Planting material
including 10% casualty
1 Seedlings 7865 770 8635
replacement in second
year
2 Manure and fertilizer 3152 4874 6685 8852 23563
Drip irrigation system
3 21675 21675
for mono crop
4 Plant protection 600 600 1200 1200 3600
5 Intercrop 0 0 0
6 Fencing 0 0
Subtotal 33292 6244 7885 10052 57473
II Labour
1 Land preparation LS 1750 1750
Digging,filling and
2 2145 2145
planting@Rs. 15/plant
Manure and fertilizer
3 4 200 200 200 200 800
application
4 Pesticide application 2 100 100 100 100 400
5 Irrigation 5 250 250 250 250
6 Interculture operations 10 500 500 500 500 2000
Harvesting @ Rs. 150
7 per ton for 4 ton in 4th 150 600 600
year
8 Watch and ward 1000 1000
Subtotal 4945 1050 1050 26509695
III Contignencies 5% 1912 365 447 635 3359
Total (rounded off) 40100 7700 9400 13300 70500

Unit cost capitalised upto 4th year (with drip irrigation system) Unit cost capitalised upto
4th year (without drip irrigation system)
Annexure III

Financial analysis

S.No Particulars Units Year
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Yield (ton
1 of FFB per 4 6 8 12 14 16 18 18 18 18 18 18
ha)
Sale price
2 3500
of FFB/ton
3 Income Rs 0 0 0 14000 21000 28000 42000 49000 56000 630006000 63000 63000 63000 63000
4 Expenditure Rs 40100 7700 9400 13300 13700 13700 14300 14600 14900 1520015200 15200 15200 15200 15200
- - -
5 Net income Rs 700 7300 14300 27700 34400 41100 4780047800 47800 47800 47800 47800
40100 7700 9400

Financial indicators
Discount factor 15%
NPV of costs 97,947
NPV of benefits 146,051
NPV of net benefits 48,104
BCR 1.49
IRR 25%

Sensitivity analysis

S.No Particulars Year
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
1 Income 10% 0 0 0 12600 18900 25200 37800 44100 50400 56700 56700 56700 56700 56700 56700
2 Expenditure 10% 44110 8470 10340 14630 15070 15070 15730 16060 16390 16720 16720 16720 16720 16720 16720
- - -
3 Net income -2030 3830 10130 22070 28040 34010 39980 39980 39980 39980 39980 39980
44110 8470 10340

Financial indicators
Discount factor 15%
NPV of costs 107,742
NPV of benefits 131,446
NPV of net benefits 23,704
BCR 1.22
IRR 20%

Conclusion:

The BC Ratio has reduced to 1.22. This means that for one rupee spent, the returns reduced to
Rs. 1.22., which is lower than the earlier value of Rs. 1.49. IRR has also reduced from 25% to
20%. The project is feasible but there is a reduction in returns after changes.

Thus, on the basis of Sensitivity Analysis, we can find out answers to the following
questions:

1. Which are the variables with high sensitivity indicators?
2. How likely are the (adverse) changes in the values of the variables that would alter the
project decision?

References:

• Pandey I.M., Financial Management.
• Brearly R.A. and Myers S.C., Corporate Finance.
• SBIRD, ardp Book, Chapter 13.
• Model Project on Cultivation of Oil Palm
• Wikipedia, Sensitivity Analysis