2.

Ans: Uses of Sensitivity Analysis

Here we discuss the uses of sensitivity analysis:

1. Developing Recommendations for the Decision-makers

2. Feasibility testing of an optimal solution
3. Identifying the sensitive variables
4. Identifying critical values and break-even point where the optimal strategy changes
5. Assessing the degree of risk involved in strategy or scenario
6. Communication
7. Allows the decision-makers to make assumptions
8. Making recommendations
9. Quantifying the parameters
10.Developing a hypothesis for testing different scenarios
11.Estimating the requirements of the input and output variables
12.Understanding the relationship between input variables and the outcome

Q. From the given table, calculate expected rate of return and range of return.
Particulars Probability Security X Security Y
Initial Outlay (₹ in Crores) 50 50
Annual return in %
Pessimistic .25 14 8
Most likely .50 16 16
Optimistic .25 18 24

Solution:
Particulars Probability Return (%) Expected Return
(a) (b) (a × b)
Security-X
Pessimistic .25 14 3.5
Most likely .50 16 8.0
Optimistic .25 18 4.5
16
Range =
Optimistic Return – Pessimistic Return 1.0
Security-Y
Pessimistic .25 8 2.0
Most likely .50 16 8.0
Optimistic .25 24 6.0
16
Range =
Optimistic Return – Pessimistic Return 4.0
Answer to the Q. No. 2: The technique used to determine how independent variable values will
impact a particular dependent variable under a given set of assumptions is defined as sensitive
analysis.

Uses of Sensitivity Analysis

1. The key application of sensitivity analysis is to indicate the sensitivity of simulation to

uncertainties in the input values of the model.
2. They help in decision making
3. Sensitivity analysis is a method for predicting the outcome of a decision if a situation
turns out to be different compared to the key predictions.
4. It helps in assessing the riskiness of a strategy.
5. Helps in identifying how dependent the output is on a particular input value. Analyses if
the dependency in turn helps in assessing the risk associated.
6. Helps in taking informed and appropriate decisions
7. Aids searching for errors in the model

Sensitivity analysis is one of the tools that help decision makers with more than a solution
to a problem. It provides an appropriate insight into the problems associated with the model
under reference. Finally the decision maker gets a decent idea about how sensitive is the
optimum solution chosen by him to any changes in the input values of one or more parameters.

For Detailed Notes- https://www.edupristine.com/blog/all-about-sensitivity-analysis#:~:text=Uses%20of

%20Sensitivity%20Analysis&text=Sensitivity%20analysis%20is%20a%20method,on%20a%20particular%20input%20value.

Answer to the Question No. 1 (a): Present Value Calculation-

Present value (PV) is the current value of a future sum of money or stream of cash flows given a
specified rate of return. Future cash flows are discounted at the discount rate, and the higher
the discount rate, the lower the present value of the future cash flows. Determining the
appropriate discount rate is the key to properly valuing future cash flows, whether they be
earnings or obligations.

Present Value Formula

Present Value = FV/ (1+r) n

Where,
FV=Future Value
r=Rate of return
n=Number of periods

Example:
Mr. X will require ₹ 50,000 in next 5 years. If he earns 6% Interest on his fund, how much will
he need to invest today in order to reach his savings goal?
Solution:
Given,
FV = ₹ 50,000
r = 6% or 0.06
n = 5 Years

∴ Present Value (PV) = ₹ 50,000/ (1+ 0.06)5

= ₹ 37,362.91
Benefits of Using Present Value Method-
The present value is easy to use and the results can be easily customized to fit your needs. You
can adjust the discount rate to reflect risks and other factors affecting the value of your
investments.
Another advantage of the net present value method is its ability to compare investments.
As long as the NPV of each investment alternative is calculated back to the same point in time,
the investor can accurately compare the relative value in today's terms of each investment.

Answer to the Question No. 1 (b): NPV

Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyze the profitability of a projected investment or project.

Example:
Calculate the net present value of a project which requires an initial investment of $243,000 and
it is expected to generate a net cash flow of $50,000 each month for 12 months. Assume that the
salvage value of the project is zero. The target rate of return is 12% per annum.

Solution
We have,
Initial Investment = ₹243,000
Net Cash Inflow per Period = ₹50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%

Net Present Value

=₹50,000 × {1 − (1 + 1%)-12} ÷ 1% − ₹243,000
= ₹50,000 × (1 − 1.01-12) ÷ 0.01 − ₹243,000
= ₹50,000 × (1 − 0.887449) ÷ 0.01 − ₹243,000
= ₹50,000 × 0.112551 ÷ 0.01 − ₹243,000
= ₹50,000 × 11.2551 − ₹243,000
= ₹562,754 − ₹243,000
= ₹319,754
1 – Time Value of Money
The primary advantage of using NPV is that it considers the concept of the time value of
money i.e a dollar today is worth more than a dollar tomorrow owing to its earning capacity. The
computation under NPV takes into account the discounted net cash flows of an investment in
order to determine its viability. To understand how present value figures are important in capital
budgeting, let us consider the following example –
Example
A company is looking to invest $100,000 in a project. The required rate of return is 10%. The
following are the projected earnings of project A and project B.

 Project A – Y1 – $10,000, Y2 – $12,000, Y3 – $20,000, Y4 – $42,000, Y5 – $55,000 and

Y6 – $90,000.
 Project B– Y1 – $15,000, Y2 – $27,500, Y3 – $40,000, Y4 – $40,000, Y5 – $45,000 and
Y6 – $50,000.
If the time value of money is not considered, the profitability of the projects would be the
difference between the total inflows and total outflows, as depicted in the table below –

Judging by these figures, Project A would be considered profitable with a net inflow of 
$129,000.

In the same example, however, if the time value of money was considered,

*Discounted at 10%
It is evident that Project B is more profitable in terms of the present value of future cash flows
with a discounted net inflow of $49,855. Therefore, it is essential that the time value of money is
considered, to determine, more accurately, the ideal investment for a company.

2 – Decision-Making
NPV method enables the decision-making process for companies. Not only does it help evaluate
projects of the same size, but it also helps in identifying whether a particular investment is
profit-making or loss-making.
Example
Let us consider the following example –
A company is interested in investing $7500 in a particular venture. The required rate of return is
10%. The following are the projected inflows of the venture –
Y1 – $(500), Y2 – $800, Y3 – $2300, Y4 – $2500, Y5 – $3000.

NPV of the project (as computed using the formula) = $(1995.9)

In the given case, the present value of cash outflow is higher than the present value of cash
inflows. Therefore, it is not a viable investment option. Another advantage of NPV is that it
helps to maximize the earnings of the entity by investing in ventures which provide the
maximum returns.

Answer to the Question No. 1 (C): Annuity

An annuity is defined by merriam-webster.com as “a sum of money payable yearly or at other
regular intervals”. Wikipedia defines an annuity as “any recurring periodic series of payment”.

Example 1: Find the future value of an ordinary annuity with $150 monthly payments at 6¼%
annual interest for 12 years.

Solution:
For this problem we are given payment amount ($150), the interest rate (.0625 in decimal form),
the compounding period (monthly or 12 periods per year), and finally the time (12 years). We
plug each of these into the appropriate spot in the formula

FV= pymt {(1+r/n) n*t – 1}/ (r/n)

= 150 {(1+ .0625/12)12*12 – 1} / (.0625/12)
= 32,051.04651

In this class we will round using standard rounding. This will make the future value $32051.05

Annuities can be helpful in some situations. In general, some of the advantages and benefits
include:
  Tax-deferred growth and compounding within the annuity contract. Which means you
only get taxed on the interest you earn once you start receiving payments, not while it's
building up.
 Guaranteed rates of return on your dollars
 Guaranteed lifetime payments if you annuitize (in some cases you don’t even have to
annuitize to receive this benefit)
 Other features that may be important to you. These are various bells and whistles that do
very specific things, ask your annuitant about these options before signing on any dotted
lines.

Answer to the Queation No. 1 (d): EMI

An equated monthly installment (EMI) is a fixed payment amount made by a borrower to
a lender at a specified date each calendar month. Equated monthly installments are used to pay
off both interest and principal each month so that over a specified number of years, the loan is
paid off in full. With most common types of loans—such as real estate mortgages, auto loans,
and student loans—the borrower makes fixed periodic payments to the lender over the course of
several years with the goal of retiring the loan.

Suppose Ram has borrowed Rs. 5 lakhs from a bank on the interest rate of 12 per cent for
10 years. Do in this case:

M (Loan period in months)        : No of Years × 12 = 10 × 12 = 120

I (Interest rate per Annum / 12): (12/100) / 12         = .01

L (Loan amount)                        : Rs. 5, 00,000    

EMI (Equated Monthly Instalments) = (5, 00,000 × .01) × (1+.01)120 / [(1+.01)120] – 1

= ₹ 7,174

So, in the example discussed above:

 EMI that Ram has to pay is Rs. 7147
 Total payment made by Ram to the bank in 10 years (EMI X Total tenure in months (7174
X 120) is Rs 8,60,880
 The total interest rate payable will be (Total payment – loan amount) Rs. 3,60,88

Advantages of EMI:

Freedom to Buy Expensive Utilities: EMI gives a chance to consumers to buy expensive

utilities which they won’t be able to buy otherwise. Be it expensive household items, a vehicle,
gifts and jewellery for wedding or a house itself, EMI helps you buy anything and everything.
As consumers get a chance to divide the amount in monthly installments and pay it off easily,
they make the purchase and enjoy the benefits. This gives an advantage to not only buyers of
such expensive utilities but also to the traders and sellers. EMIs are like a wishing bone for
common man.

Easy on Wallets: The borrower can pay the loan in monthly installments by opting EMI
scheme. The amount is determined on the basis of principal loan amount, tenure, interest rate
and the borrower’s ability of repayment. This makes it easier for the borrowers to pay off the
said amount in small chunks every month. Thus they don’t have to pinch their monthly expenses
to afford various expensive utilities.

Flexible EMI Options by Banks: Many banks now-a-days offer flexible EMI options to the
borrowers. The EMIs are adjusted and decided as per the borrower’s needs. The installment and
tenure is decided by the borrower as per his or her convenience.