GROUP HOMEWORK CASE 15

Lecturer: Tandelilin Eduardus, Prof., Dr., M.B.A.

Group 14
Steven Nathanael Liyanto 22/492125/EK/23702
Naufal Hafizha Buana 22/492398/EK/23754
Hend Manai 23/523843/NEK/27692

DEPARTMENT OF ACCOUNTING & MANAGEMENT

FACULTY OF ECONOMICS & BUSINESS
UNIVERSITAS GADJAH MADA
2023
 Questions:
1. Why should sensitivity analysis be a part of the company’s capital budgeting process?
2. Explain the role of weighted average cost of capital in the capital budgeting process.
3. Interpret the additional data and information given in the case for Projects A,B, and C.
Determine the sensitivity of Project B changes in the annual cash inflows in and to
changes in net outlay. To which change is the project’s economic value more sensitive?
Why might this be the case?
4. Should any new conclusions be drawn concerning any of the three projects? If so, what
are they?
5. In the two-dimensional sense (i.e. cost of capital and net present value/IRR), which of
these has been altered by the calculation in Question 3? What does this result mean for
the company’s future capital budgeting efforts?
6. Is Garrison’s decision to use previously approved projects as an example of sensitivity
analysis sound? Why or why not?
7. How would the call for sensitivity analysis be incorporated into the firm’s capital
budgeting manual?
8. Why might there be resistance to this idea at various levels?
9. How should such resistance be handled and by whom?
10. Comment upon need, or lack thereof, to update or revise the list of economic variables
that go into the sensitivity analysis.

Answers:
1. Sensitivity analysis is an important technique in capital budgeting that allows businesses
to assess the impact of changes in key factors on project financial results. Here are some
of the reasons why sensitivity analysis should be included in the capital planning process
at your company:
a) Identify essential factors: Sensitivity analysis assists businesses in identifying the
most critical variables that impact the profitability of a project. Companies can
determine the extent of influence on the project's financial outcomes by adjusting
the values of these factors. This information can assist businesses in making better
informed judgments about whether or not to invest in a certain project.
b) Assess risk: Sensitivity analysis also assists businesses in determining the amount
of risk involved with a project. Companies can estimate the amount of uncertainty
associated with the financial results of a project by examining the impact of
changes in key factors. This information can assist businesses in making better
educated decisions about the degree of risk they are prepared to accept.
c) Improve decision-making: By performing sensitivity analysis, businesses may
make better informed judgments about whether or not to invest in a certain
project. This data can help businesses allocate resources more effectively and
make better use of their money.
2. The weighted average cost of capital (WACC) is a critical concept in capital planning.
WACC contributes to capital budgeting in the following ways:
a) Discount rate: WACC is utilized as the discount rate for calculating a project's net
present value (NPV). The NPV is a measure of a project's worth in today's dollars,
and it is computed by discounting the project's predicted cash flows using the
WACC. If the NPV is greater than zero, the project is deemed financially feasible.
b) Cost of capital: WACC is also used to calculate a company's cost of capital. It
shows the average cost of debt and equity financing for the firm, weighted by the
percentage of each in the capital structure. Companies can establish the minimal
rate of return that a project must earn to be financially viable by utilizing WACC
as a measure of the cost of capital.
c) Capital structure: WACC may also be used to assess the impact of changes in a
company's capital structure on its cost of capital. For example, if a corporation
expands its usage of debt financing, its WACC may fall since interest payments
are tax deductible. Companies may make better informed judgments regarding
their financing options by examining the impact of changes in capital structure on
WACC.

3.
The new data and information provided for Project A has increased the net spend
from $100,000 to $115,000. Because of the 20% drop in cash inflow, the cash flow for
Year 1 is $16,000, Year 2 is $12,000, Year 3 is $24,000, Year 4 is $48,000, and Year 5 is
$40,000. As a result, the NPV of $25,144.83 has been reduced to - $14,884.14. The IRR
has likewise dropped from 17.56% to 5.69%. The following equation is used to calculate
the NPV and IRR for all projects:

NPV = F [(1+i) n ]
F = Future payment (cash flow)
i = Discount rate (or interest rate)
n = the number of periods in the future the cash flow

We apply the same calculation as for NPV to calculate IRR. However, we set the
NPV to zero and solve for the discount rate (i), which is the IRR in this situation.

Due to the interruption in labor supply, the additional data and information
provided for Project B increased the initial net outlay of $75,000 by 10% to $82.500.
Furthermore, cash inflows did not meet expectations; in Year 1, the predicted cash inflow
was only 90%, 80% in Year 2, and 85% in Year 3. As a result, the cash inflow in Year 1
was $27,000, $33,600 in Year 2, and $27,200 in Year 3. Without taking into account the
other factors, Project B has an NPV of $11,025.54 and an IRR of 18.05%. However,
when the base case was examined for changes in the variables, the NPV was reduced to
$5,301.00 and the IRR was reduced to 3.17%. The extra data for Project C boosted the
net spend from $200,000 to $220,000. If one of the firm's key clients is unable to resume
their production facilities, the annuity from Years 3 to 8 becomes $38,250 rather than
$45,000. Before the extra data, Project C had an NPV of $26,583.62 and an IRR of
12.63%. After accounting for changes in net outlay and cash inflow, the NPV has
dropped dramatically to -$17,712.26 and the IRR to 8.3%.

To determine the sensitivity of Project B to changes in yearly cash inflow and net
outlay, a base value of NPV must be established to compare NPV changes relative to
input changes. In this scenario, we will utilize the base NPV, which is $11,025.54 without
the additional data and information. To determine the sensitivity of the net outlay, we will
first calculate the NPV of the change in net outlay ($82,500) while all other inputs remain
constant. As a result, the cashflow with the change in net outlay and its revised NPV from
the extra information would be as follows:

Year 0 Year 1 Year 2 Year 3 NPV

($82,500) $30,000 $42,000 $32,000 $3,525.544703

The aforementioned data would be entered into the sensitivity equation, which
evaluates the percentage change in NPV relative to the % change in input, as shown
below:
SI= (NPVb−NPV 1 )/NPV b (Xb−X1 )/ Xb
Xb – value of variable in the base case
X1 – value of the variable in the sensitivity test
NPVb – value of NPV in the base case
NPV1 – value of the variable in the sensitivity test
SI= (11,025.54−3,525.54)/11,025.54 (75,000−82,500)/75,000
¿−6.80238

We must compare the sensitivity of the change in net outlay to the sensitivity of
the change in cash inflow. Thus, the cashflow with the change in cash inflows based on
the extra information supplied to Garrison and its updated NPV would be as follows:

Year 0 Year 1 Year 2 Year 3 NPV

($75,000) $27,000 $33,600 $27,200 -$2,250.18789

The data above would also be inserted to the sensitivity equation which results in
the calculations below:
 SI= (11,025.54−(−2,250.18789))/11,025.54 (34,666.67−29,266.67)/34,666.67
¿7.72995

According to the sensitivity analysis, the NPV of Project B's economic value is
more sensitive to changes in cash inflow than to changes in net spending. The sensitivity
analysis of the cash influx reveals that for every $1 increase in cash input, the production
(NPV) rises by up to $7.72995. The sensitivity analysis for net outlay demonstrates that
for every $1 increase in net outlay, the NPV drops by as much as $6.8. As a result of the
findings, Garrison should prioritize estimating cash inflows as accurately as possible
above lowering net outlay since cash inflows have a greater impact on the NPV of Project
B. This might be the case since the cash inflow is not just for one year but for three years,
increasing the probability of variation compared to net spending.

4. The cost of capital remains constant at 10% across all three projects. However, the Net
Present Value (NPV) and Internal Rate of Return (IRR) vary as each project interacts
with external variables. The case indicates that external factors affect the IRR and NPV,
despite the stable cost of capital.

The NPV and IRR are closely related, where a higher IRR implies a higher NPV. Projects
with IRR exceeding their cost of capital are preferred because it signifies that the present
value of expected cash inflows surpasses the present value of expected cash outflows.

When comparing two projects, the NPV and IRR may sometimes yield different insights.
A project with a low IRR but a high NPV suggests slower returns but substantial overall
value addition. One challenge with IRR is comparing projects with differing timeframes;
shorter projects tend to have higher IRR due to quicker returns, while longer projects may
have lower IRR, but they offer steady, long-term value to the company.

The sensitivity analysis results for projects A, B, and C, considering the impact of
external variables on their NPV and IRR, demonstrate that a project's sensitivity to these
variables affects the NPV. In this context, Kirby Corporation is more sensitive to cash
inflows than to net outlays, indicating that changes in cash inflows have a more
significant impact on NPV.

5. .

The calculation in Question 3 has specifically altered the perspective of net present value (NPV)
and internal rate of return (IRR) in the two-dimensional sense of the cost of capital. This
alteration is primarily due to the sensitivity analysis performed, which considers the impact of
changes in cash inflow and net outlay on Project B's NPV and IRR.

The key change is related to how sensitive NPV is to variations in cash inflow compared to net
outlay. In this analysis, it is evident that NPV is more sensitive to changes in cash inflow. This
means that relatively small changes in cash inflow can have a more significant impact on Project
B's NPV compared to changes in net outlay.

The sensitivity analysis demonstrates that the NPV of Project B is more sensitive to changes in
cash inflow compared to changes in net outlay. Specifically, for every $1 increase in cash inflow,
the NPV of Project B increases by approximately $7.73, while for every $1 increase in net
outlay, the NPV decreases by approximately $6.80.

● Focus on Cash Inflows: The company should place a strong emphasis on ensuring the
accuracy and reliability of its cash inflow estimates. Small changes in cash inflows can
significantly impact the economic value of the projects. Therefore, efforts to improve
revenue generation and cash flow management should be prioritized.

● Risk Assessment and Mitigation: The company should recognize that the sensitivity of
NPV to cash inflows implies a higher level of risk in projects dependent on revenue. This
necessitates a proactive approach to risk assessment and mitigation, including
diversifying revenue sources and implementing risk management strategies.

● Strategic Decision-Making: When comparing projects for future capital budgeting, the
company should consider the sensitivity of NPV to external variables. Projects that
exhibit greater sensitivity to cash inflow changes may be seen as riskier and may require
higher expected returns to justify the risk.

● Continuous Monitoring: Sensitivity analysis should be an ongoing part of the capital

budgeting process. As new data becomes available or circumstances change, the
company should regularly review and update its sensitivity analysis to make
well-informed decisions.

6. In this instance, Garrison's choice to use previously sanctioned budget proposals as the
foundation for her sensitivity analysis was driven by her desire to underscore why Kirby
Corporation should consider employing current projects to exemplify the importance of
this analytical approach. However, it's worth noting that the results of the sensitivity
analysis applied to these prior projects are unlikely to significantly impact Kirby
Industries' future returns since they were already approved in advance. Furthermore, the
analysis failed to incorporate numerous quantifiable factors, such as inflation projections,
 which can influence cost components and cash inflows. Consequently, the data used in
the sensitivity analysis may lack accuracy. Nevertheless, this serves as a valuable initial
step for Kirby Industries in their future capital budgeting planning efforts and should be
incorporated into the capital budgeting manuals. This inclusion further aids Garrison in
demonstrating the significance of sensitivity analysis within the organization.

In summary, Garrison's decision to use previously approved projects as examples of

sensitivity analysis can be sound in the context of educational and awareness-raising
objectives. However, it is crucial to communicate the limitations of such an approach,
especially regarding its relevance and accuracy for current and future projects. Sensitivity
analysis should ideally be performed with current and comprehensive data to provide a
more accurate basis for investment decisions.

7. Sensitivity analysis is an approach that helps project managers predict their focus on
important factors and identify areas where further research could be useful before
approving a project. Additionally, a corporation might benefit from the use of a specific
boundary correlated with variables like labor costs, input costs, inflation, and other
quantifiable risk in case the project estimation proves to be inaccurate. Not only that,
prior to making an investment, sensitivity analysis can be used to gauge how these factors
can produce the anticipated effects.

8. Resistance might happen if the value concerning external variables is higher than the
value of concerning internal variables. There are two possible outcomes when it comes to
IRR: first, the IRR when only internal variables are taken into account is higher than the
10% stated cost of capital. Second, the IRR when external variables are taken into
account is lower than 10%. IRR values that are higher than the cost of capital are better in
this situation. The NPV declined when the corporation took external factors into account,
exhibiting the same scenario. indicating that when additional factors are taken into
account, the NPV tends to go negative.

Since the possibility for the shortfall was unknown until the project was submitted,
resistance to this idea also existed. Disagreements might arise from Kirby Company's
propensity to apply sensitivity analysis to external factors, as they have never taken into
account external factors like cost increases for the various labor and raw material,
inflation projections, cash inflows, and other quantifiable risk aspects in their project
before. Especially the fact that the value of considering external factors is lower, makes
this project have more resistance.
9. Resistance might happen from the shareholders because of their unconfident about the
project, so it is the job for the managers and decision-makers to ensure the uncertainties
from the shareholders by decision model sensitivity analysis. utilizing a decision model,
which requires us to confirm that all of the data it contains is provided. As a result, every
variable required for the decision model can function to its fullest extent, assisting
decision analysts in comprehending the scope of a decision model and providing
investors or shareholders with an explanation.

10. Many economic variables can be included in the sensitivity analysis. However, in this
instance, only curtain variables like cash flows, growth rate of cash flows, and cost of
capital are included. While depreciation, inflation, tax rate, and other economic factors
can be included in the sensitivity analysis, the projects that are currently underway may
be impacted by these factors in the future. As a result, managers and other
decision-makers need to be informed and ought to evaluate the projects' risk level more
precisely.