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134 Financial Management

Procedure

Fairly simple, sensitivity analysis consists of the following steps:

1. Set up the relationship between the basic underlying factors (like the quantity
   sold, unit selling price, life of the project, etc.) and net present value (or some
   other criterion of merit).


2. Estimate the range of variation and the most likely value of each of the basic
   underlying factors.


3. Study the effect on net present value of variations in the basic variables. (Typi-
   cally one factor is varied at time.)
   Illustration
   Anischit Enterprises is analysing an investment proposal. The following net present
   value relationship has been set up:

NPV =

[ ( ) ]( )

( ) ( )

QP V F D T D

r

S

t t rn

n - - - - +

+

+

+

• =

1

1 1

1

1

...(8.1)

where NPV = net present value of the project

Q = number of units sold annually

P = selling price per unit

V = variable cost per unit

F = total fixed cost, excluding deprecation and interest

D = annual depreciation charge

T = income tax rate

r = cost of capital

n = project life in years

S = net salvage value

I = initial cost.

The range and most likely value of each of the basic variables are given in

Table 6.3

Table 6.3: Range and Most Likely Value of Basic Variables

Variables Range Most Likely Value

Rs. Rs.

Q 1,000 - 2,000 1,600

P 600 - 1,000 750

V 300 - 500 400

F 120,000 - 120,000 120,000

D 160,000 - 160,000 160,000

T 0.60 - 0.60 0.60

r 0.08 - 0.11 0.10

n 5 - 5 5

S 400,000 - 400,000 400,000

I 1,200,000 - 1,200,000 1,200,000