UNIT IV

Capital Budgeting
News Analysis
 Sensitivity Analysis

• Sensitivity Analysis may be defined as a process of

analyzing change in IRR and NPV of the project for a
given change in one of the variables.
• If NPV of the project is more sensitive, then, the
variable will be more critical.
• It states that:
i. What will be change in the IRR or NPV when there is
change in selling price, sale volume, market size( or
other variables);
•
.
ii. What will be change in the IRR or NPV, when there
is change in variable costs.
Any change in any variable may bring change in IRR or
NPV. As a result the reliability of accurate estimate of
NPV and IRR remains uncertain.
So, to overcome this problem, sensitivity analysis uses
these three estimates:
a.Optimism
b.Most Likely
c. Pessimistic
 ……………….to be continued
• Illustration: Mr. A is considering two mutually
exclusive projects P and Q. The cut-off is 15% .
Advise the management about the accepting of
project A or B. The particulars are as under:
Project P (rs.) Project Q (rs.)

Investment( cost) 100,000 100,000

Forecast cash inflows per annum
for 5 yesrs
optimistic 60,000 80,000
Most likely 40,000 40,000
pessimistic 30,000 10,000
 ……………to be continued
Project P Project Q

Annual Discount PV NPV Annual Discount PV NPV

Cash Factor Rs Rs Cash Factor Rs Rs
Inflow @ 15% Inflows 15%
s

Optimistic 60000 3.3522 201,132 +101,13 80,000 3.3522 2,68,166 168,166

2

Most 40000 3.3522 134,088 +34,088 40,000 3.3522 134,088 -34,088

Likely

Pessimisti 30000 3.3522 1,00566 +566 10000 3.3522 33522 -66,478

c
• Merits
1.Identifies all those variables which affect cash flows
estimates;
2.It focuses on critical variables that are required to
implement project effectively
3.It helps to focus on relevant variables by exposing
inaccurate estimates
 .

• Demerits:
• 1. The lack of clarity in results
• 2. Does not state about the interrelationship
between variables
Scenario Analysis

Scenario analysis measures the

change in NPV of the project under
different scenarios changing several
variables at a time because of
interrelationship of variables among
themselves.
Simulation Analysis
• Simulation is an exercise that generates
large number of NPVs their expected
value and standard deviation.
• Known as the Monte Carlo simulation,
this technique tries to overcome the
objection with scenario analysis. This
Monte Carlo simulation is complex and
can’t be considered a suitable technique
if computers are not available.