Risk Analysis in Capital Investments 211YearsVariable 1 2 10
Sales growth rate (percent)
Pessimistic 11 11 10
Most likely 13 13 12
Optimistic 15 15 14
Operating profit margin (percent)
- Pessimistic 11.5 11.5 11
- Most likely 12 12 11.5
- Optimistic 12.5 12.5 12
Market growth rate (percent) - Pessimistic 10 10 9
- Most likely 11 10.5 10
- Optimistic 12.5 12 11.15
The ‘best case–worst case’ analysis does not tell us about the likelihood of the best case or the worst case.
The worst case, as many executives assume, is one in which competition is the greatest, input costs are the
highest, selling price is the least–and so on. The probability of all these happening together is very low.
SENSITIVITY ANALYSIS
Cash flow used for the computation of NPV is based on assumptions regarding selling price, sales quantity,
market share, market growth, capacity utilization—and so on. The NPV corresponding to the most likely
values of these variables is referred to as the base-case. Due to the uncertainty, variables can take on a range
of values rather than a single value. For instance, for the picture tube project mentioned in an earlier chapter,
BEL assumed a selling price of Rs 500 each for a 20-inch picture tube. But the selling price can vary between
Rs 475 and Rs 525. The management has estimated Rs 500 as the most likely value. The sensitivity of NPV
(or IRR or ROI) can be found for various likely values of selling price or any variable that can affect the
decision rule significantly.
Sensitivity analysis refers to the process of changing variables or assumptions to determine their impact
on a project’s profitability. It does not involve the use of probabilities. To conduct a sensitivity analysis:
- Estimate the base case NPV or IRR based on most likely values of variables.
- Identify the key variables (those that are expected to affect the project profitability significantly).
- Change one variable, say selling price, at a time keeping all others unchanged and compute NPV or IRR.
Carry out the exercise for all the possible values of the variable. - Repeat for all variables.
Executives of BEL, who were setting up a black and white picture tube project in the early 1990s, calculated
the NPV for the picture tube project based on the following assumptions:
- Sales price per unit:
20" picture tube = Rs 500
14" picture tube = Rs 325 - Output as percentage of plant capacity = 60 percent, 76.24 percent, and 100 percent for the first, second
and third year respectively, for both the sizes. The output is expected to remain at third year level for the
remaining years.