Sensitivity analysis

Dr. P. I. Ayantha Gomes

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 The financial and economic benefit-cost analysis of projects is based on

forecast of quantifiable variables (e.g. number of rooms rented, room rate
per day- Rs per full board, etc).
The values of these variables are estimated based on the most probable
forecasts, which may cover a long period of time (e.g. a hotel may operate
for 10+ years under the same company).
However, the actual values of these variables may differ considerably from
the forecasted values due to various reasons (e.g. demand for rooms may
go down when more hotels come to existence)
It is therefore necessary to consider the effects of likely changes in the key
variables on the viability (e.g. Impact of reduced demand for rooms on
profit)
In sensitivity analysis input variables are varied to check change of an
output variable
This will help the engineer to consider the alternatives as well as the
potential risks of decisions he/she took

What is the standard procedure of

sensitivity analysis?
No optimal sensitivity analysis procedures exist,
and the method depends on the problem

Example 1
A company invests for a Hotel project and the
free cash flow is Rs 100 million. The weighted
average cost of capital is 10% and the growth
rate is 3%. Find (i) terminal value (ii) how
sensitive the terminal value for changes in
rates estimated/forecasted for cost of capital
and growth rate?

(i)

Free cash flow (Rs)

100

WACC

10%

GR
Terminal value (Rs)

3%
1428.571

(ii)

GR

1428.571
8%
9%
10%
0%
1250 1111.111
1000
1% 1428.571
1250 1111.111
2% 1666.667 1428.571
1250
3%
2000 1666.667 1428.571
4%
2500
2000 1666.667
5% 3333.333
2500
2000

COC
11%
12%
909.0909 833.3333
1000 909.0909
1111.111
1000
1250 1111.111
1428.571
1250
1666.667 1428.571

13%
769.2308
833.3333
909.0909
1000
1111.111
1250

14%
714.2857
769.2308
833.3333
909.0909
1000
1111.111

15%
666.6667
714.2857
769.2308
833.3333
909.0909
1000

This table shows how sensitive terminal value is to changes in cost of capital and
growth rate

Variation of both variables

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Example 2
Eagle Airlines has expansion plan. Currently 50% of flights are scheduled
and 50% are chartered.
A new seneca airplane costs 85000-90000USD. However, this price may go up
to 95000 USD if the purchase agreement is not made within two months.
It has 5 passenger seats. Operating cost is 245/hour. Annual fixed cost is 20000
USD (including insurances and finance charges).
The company needs to borrow 40% of the money 2% above the prime interest
rate of 9.5% (consider this includes the interest as well as the capital
component).

It is estimated that the company is able to charge 300-350 USD per hour
for charter or 100 USD per person for scheduled flights. Scheduled flights
on average is half full. Company hopes that the airplane fly 1000
hours/year with 800 being more realistic.
Other options the company has:
Invest in Bank with 8%
Rent airplane with 2500-4000USD
(Example was taken from Clement RT (1996) Making Hard Decisions: An
Introduction to Decision Analysis. Duxbury Press)

 Step 1: Consider the options available and

factors govern them. Also compare options
with objectives.
Separate sensitivity analyses need to be carried
out for each option/alternative. Here we will
consider the option of maximising profit.

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 Step 2: Draw a sketch for all influencing factors

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Input variables

Out put variable

Intermediate variables

 Step 3: show the values of all variables

(preferably in tabular form)

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