sensitivity in investment appraisal Flashcards
(14 cards)
what is the difference between risk and uncertainty?
risk = range of outcomes, each with known probability, and probability assessed by reference to past information.
uncertainty = range of outcomes unknown, probability unknown, and range and probability of outcomes unknown.
what factors influence cost of capital? how do the difference investment appraisal techniques deal with this?
interest and inflation - can change over short periods of time an org may wish to use different rates over the life of the project. NPV and discounted PV allow this, but IRR and ARR present uniform rate of return. using NPV a different discount factor can be used every year. one of the main issues with DCF method is deciding the rate. difficult enough in Y1, but Y4 can be even harder because of economic changes. if low rate is chosen almost everything will be accepted and if high you may miss opportunities.
what is retrospectively found when looking at discount rates in practice?
looking back, majority of mgrs pick too high a rate and have missed growth opportunities. no prizes for being conservative, just as much a failing as being too optimistic. sensitivity analysis can help with doubt over correct discount rate to be used.
what is a risk adjusted rate?
add a premium to the cut off rate whereby more marginal projects would be less likely to have positive NPV.
useful scheme is to have risk category schedule providing gradings leading to a cut of rate being decided. difficultly with risk adjusted rates lies mainly in need for skilful mgment judgement as to risk category, even though considerable research may have been undertaken.
what is sensitivity analysis?
Sensitivity analysis is a modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome. Particular attention is thereafter paid to variables identified as being of special significance.
what are the two basic approaches to sensitivity anaylsis?
- single input changed at a time
analysis made of key input factors to ascertain how much each factor must change before NPV reaches 0 (indifference point). sensitivity margin = NPV / PV of flow under consideration. this works for total cash flows but cannot be used for individual units.
- specific changes are calculated - e.g. 5% decrease in sales - to determine effect on NPV
how is sensitivity analysis applied in practice?
as carried out in context of a specific thing happening, easy to apply. any outcome that appears critical as an outcome can be examined in more detail before final decision made. very easy to use spreadsheets for this by using changeable input cells as references.
usefulness of SA is in role as attention-directing technique, as shows factors with most significant impact on outcome of project. armed with this, mgment can take action to make sure events that are within their control stay within the parameters they set.
what are the four steps in sensitivity analysis?
- select variables to which project decision may be sensitive
- determine extent to which value of such variables may differ from base case
- calculating effect of different values on project results by recalculating the NPV
- interpreting the results
what is the switching value in sensitivity analysis?
values where if changes exceed the project decisions will change
what is important to consider when applying sensitivity analysis?
sensitivity analysis looks at one factor at a time and in reality different inputs may move together. important to consider effects of several or all variables together.
can use probability of most likely outcomes for each factor (e.g. likelihood of project life being 1 year (if 1 year is deemed the most likely outcome) and cost of labour being £x). these probabilities are assumed to be independent so can multiply them together to get probability of two or more happening at the same time, and see the likelihood of your assumed most likely NPV.
how can you compare the sensitivity of two projects?
can use a graph of NPV vs demand. the NPV may not change completely linearly but we can assume its approximately linear. can start with two coordinates - the NPV at the highest and lowest points for each project - and assume a fairly linear line. can see which project is preferable for the factor being changed
what are the pros of sensitivity analysis?
simple
helps make informed decisions - subjective judgement used
identifies critical estimates - areas crucial to success of project.
what are the weaknesses of sensitivity analysis?
assumes changes can be made independently - e.g. if material price increases the firm may increase the sales price, but SA doesn’t facilitate this modelling
only identifies how far variable needs to change - not how likely it is to actually change. if sensitivity margins are large but change is very likely this should be considered.
doesn’t give definitive decision.
what is decision tree analysis helpful for?
taking account of TVOM in decisions. can find EV of project where, for example, you choose whether to develop and then whether to market a product by multiplying cash flows by relevant discount factors
