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Finance Sensitivity Analysis PDF
Finance Sensitivity Analysis PDF
ABSTRACT: The viability of investment projects is based on IRR and NPV criteria.
In the economic analysis of the projects there are some aspects of project feasibility which may
require sensitivity and risk analysis. Sensitivity analysis estimates the effect on achieving
project objectives if certain assumptions materialize or not. This paper presents the purpose of
sensitivity analysis and the steps that must be followed in order to perform a sensitivity analysis
as well as a numeric example.
KEY WORDS: investment project, NPV, IRR, sensitivity analysis, base-case, key
variables, sensitivity indicator, switching value
1. INTRODUCTION
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Lecturer, Ph.D., University of Petroani, Romania, [email protected]
Lecturer, Ph.D., University of Petroani, Romania, [email protected]
34 Iloiu, M.; Csiminga, D.
In the economic analysis of the projects, there are also other aspects of project
feasibility which may require sensitivity analysis. These include:
1. demand analysis: to assess the sensitivity of the demand forecast to changes in
population growth, per capita consumption, prices, etc.
2. least cost analysis: to verify whether the selected least-cost alternative remains the
preferred option under adverse conditions
3. sustainability analysis: to assess possible threats to the sustainability of the project
4. distributional analysis: to analyse whether the project will actually benefit the poor.
Sensitivity analysis is particularly concerned with factors and combinations of
factors that may lead to unfavourable consequences. These factors would normally
have been identified in the project (logical) framework as project risks or project
assumptions. Sensitivity analysis tries to estimate the effect of achieving project
objectives if certain assumptions do not, or only partly, occur.
Economic PV 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
statement @12%
Benefits 2,104 0 283 339 396 453 509 566 566 566 566
Costs: 1,978 1,889 61 61 61 61 61 61 61 61 61
-Investment 1,687 1,889 0 0 0 0 0 0 0 0 0
-O&M 291 0 61 61 61 61 61 61 61 61 61
Net cash 126 -1,889 222 278 335 391 448 505 505 505 505
flow
2. Towards the Internal Rate of Return. 2. Towards the Internal Rate of Return.
Compares percentage change in IRR The percentage change in a variable or
above the cut-off rate with percentage combination of variables to reduce the IRR to
change in a variable or combination of the cut-off rate (=discount rate).
variables.
Expression 1.Towards the Net Present Value 1.Towards the Net Present Value
(NPVb NPV1) / NPVb (100 x NPVb) (Xb X1)
SI = --------------------------------- SV = ---------------------- x -------------
(Xb X1) / Xb (NPVb NPV1) Xb
where: where:
Xb value of variable in the base case Xb value of variable in the base case
X1 value of the variable in the sensitivity X1 value of the variable in the sensitivity
test test
NPVb value of NPV in the base case NPVb value of NPV in the base case
NPV1 value of the variable in the NPV1 value of the variable in the sensitivity
sensitivity test test
36 Iloiu, M.; Csiminga, D.
2.Towards the Internal Rate of Return 2.Towards the Internal Rate of Return
where: where:
Xb value of the variable in the base case Xb value of variable in the base case
X1 value of the variable in the sensitivity X1 value of the variable in the sensitivity
test test
IRRb value of IRR in the base case IRRb value of IRR in the base case
IRR1 value of the variable in the IRR1 value of the variable in the sensitivity
sensitivity test test
d discount rate d discount rate
Calculation 1.Towards the Net Present Value 1.Towards the Net Present Value
example Base Case: Base Case:
Price = Pb = 300 Price = Pb = 300
NPVb = 20,912 NPVb = 20,912
Scenario 1: Scenario 1:
P1 = 270 (10% change) P1 = 270 (10% change)
NPV1 = 6,895 NPV1 = 6,895
2.Towards the Internal Rate of Return 2.Towards the Internal Rate of Return
Base Case: Base Case:
Price = Pb = 300 Price = Pb = 300
IRRb = 15,87% IRRb = 15,87%
Scenario 1: Scenario 1:
P1 = 270 (10% change) P1 = 270 (10% change)
IRR1 = 13,31% IRR1 = 13,31%
d = 12% d = 12%
= 6,61 = 15,1%
Interpretation a) percentage change in NPV A change of approximately 15% in the price
respectively variable is necessary before the NPV
b) percentage change in IRR above becomes zero or before the IRR equals the
the cut-off rate (12%) is larger than cut-off rate.
percentage change in variable: price is a
key variable for the project
Characteristic Indicates to which variables the project Measures extent of change for a variable
result is or is not sensitive. Suggests which will leave the project decision
further examination of change in variable. unchanged.
The switching value is, by definition, the reciprocal of the sensitivity indicator.
Sensitivity indicators and switching values calculated towards the IRR yield slightly
different results if compared to Sis and SVs calculated towards the NPV. This is
Project Risk Evaluation Methods - Sensitivity Analysis 37
because IRR approach discounts all future net benefits at the IRR value and the NPV
approach at the discount rate d.
In the base case, the ENPV is 126 and the EIRR is 13.7 percent. The sensitivity
of the base case ENPV has been analyzed for (adverse) changes in several key
variables, as follows:
1. an increase in investment cost by 20 percent
2. a decrease in economic benefits by 20 percent
3. an increase in costs of operation and maintenance by 20 percent
4. a delay in the period of construction, causing a delay in revenue generation by one
year
Proposed changes in key variables should be well explained. The sensitivity
analysis should be based on the most likely changes. The effects of the above changes
are summarized in table 3.
4. CONCLUSIONS
The paper presents two concepts: sensitivity indicator and switching value,
used to perform a sensitivity analysis as well as the meaning of them. Sensitivity
indicators and switching values are calculated for the NPV and IRR, as we can see in
the numerical example, so we can analyze the effects of changes in key variable and
minimize the project risk.
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