Chapter 6
Risk Analysis
09-Oct-20 1
Methods of Describing Risk
• Sensitivity Analysis
A sensitivity analysis reveals how much
NPW (or some other criteria of merit
such as NFW, IRR & BCR) will change
in response to given change in input
variable.
09-Oct-20 2
Sensitivity Analysis
• Question no: 1
Perform sensitivity analysis using IRR over range of
±30 % in a) initial investment b) Net annual revenue
C) Salvage value & d) useful life.
Initial investment (I) = Rs 2,00,000
Annual revenue (R) = Rs 50,000
Annual Expenses (E) = Rs 5,000
Salvage Value (SV) =Rs 25,000
Useful life (N) = 10 yrs
MARR = 12%
09-Oct-20 3
Sensitivity Analysis
Solution
Using NPV ,Prime Equation becomes:
(50,000 – 5,000)(P/A,i%,10) + 25,000 (P/F, i%,
10) - 2,00,000 =0 ……………..(A)
45,000* + 25,000* -2,00,000 =0
Solving,
i= 0.1895=18.95%=IRR
09-Oct-20 4
Sensitivity Analysis
a) When capital investment (I) varies ± 30%
@ +30% ; I= 2,00,000*1.3 =2,60,000
@ -30%; I=2,00,000*0.7 = 1,40,000
At I= 2,60,000, using NPV to find IRR eqn (A)
becomes;
(50,000 – 5,000)(P/A,i%,10) + 25,000 (P/F, i%, 10) -
2,60,000 =0
45,000* + 25,000* -2,60,000 =0
09-Oct-20 5
Sensitivity Analysis
I = 0.122=12.20%=IRR
At I= 1,40,000, using NPV to find IRR eqn (A)
becomes;
(50,000 – 5,000)(P/A,i%,10) + 25,000 (P/F, i%,
10) – 1,40,000 =0
Or,45,000* + 25,000* -1,40,000 =0
Or, I=0.3023= 30.23%=IRR
09-Oct-20 6
Sensitivity Analysis
b) When net annual revenue (R-E) varies by ±
30%,
At +30%,
(50,000 – 5,000)*1.3(P/A,i%,10) + 25,000 (P/F,
i%, 10) - 2,00,000 =0
Or,58,500* + 25,000* -2,00,000 =0
Or, I=0.2684= 26.84%=IRR
09-Oct-20 7
Sensitivity Analysis
At -30%,
(50,000 – 5,000)*0.7*(P/A,i%,10) + 25,000 (P/F,
i%, 10) - 2,00,000 =0
Or,31,500* + 25,000* -2,00,000 =0
Or, I=0.1035= 10.35%=IRR
09-Oct-20 8
Sensitivity Analysis
c) When salvage value varies by ± 30%,
At +30%;
(50,000 – 5,000)(P/A,i%,10) + 25,000*1.3* (P/F,
i%, 10) - 2,00,000 =0 ……………..(A)
45,000* + 32,500* -2,00,000 =0
Solving,
i= 0.1913=19.13%=IRR
09-Oct-20 9
Sensitivity Analysis
At -30%;
(50,000 – 5,000)(P/A,i%,10) + 25,000*0.7* (P/F,
i%, 10) - 2,00,000 =0 ……………..(A)
45,000* + 17,500* -2,00,000 =0
Solving,
i= 0.1876=18.76%=IRR
09-Oct-20 10
Sensitivity Analysis
D) When useful life varies by ± 30%,
At +30%, N=10*1.3=13
(50,000 – 5,000)(P/A,i%,13) + 25,000 (P/F, i%, 13) -
2,00,000 =0
Or,45,000* + 25,000* -2,00,000 =0
Solving,
i= 20.79%=IRR
09-Oct-20 11
Sensitivity Analysis
At -30%, N=10*0.7=7
(50,000 – 5,000)(P/A,i%,7) + 25,000 (P/F, i%, 7) -
2,00,000 =0
Or,45,000* + 25,000* -
2,00,000 =0
Solving,
i= 14.46%=IRR
09-Oct-20 12
Sensitivity Analysis
If we put the values in tabular form
-30% 0% +30%
Capital 30.23 18.95 12.20
Investment (I)
Annual cash 10.35 18.95 26.84
flow (A)
Salvage value 18.76 18.95 19.13
(SV)
Useful life (N) 14.46 18.95 20.79
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Sensitivity Analysis
• Here, I & A seems to be sensitive. Among I &A
investment (I) is more sensitive.
09-Oct-20 14
Question No.2:
A real- state developer seeks to determine the most economical
height for a new office building which will be sold after 5 yrs. The
relevant net annual revenue & net resale are given below.
Height Height
4 floors 5 floors
First cost (000) 1,25,000 2,00,000
Annual revenue (000) 19,910 37,815
Net Resale Value (000) 2,00,000 3,00,000
The developer is uncertain about the interest rate ‘I’ to use, but
is certain that is in range of 5 to 30 % for each building height,
find the range of values of ‘I’ for which that building height is
most economical. Draw sensitivity diagram to support your
answer.
09-Oct-20 15
Sensitivity Analysis
Solution:
For 4 floor building:
Using PW formulation, prime equation becomes
-1,25,000+ 19,910 (p/A, i%, N)+2,00,000(p/F, i%, N)
=-1,25,000+19,910 * +2,00,000* ..(A)
Using interest rates from 5% to 30%;
PW @ 5% = 1,17,905.1138
PW @ 10% = 74,658.8291
PW @ 15% = 41,176.7550
PW @20% = 14,918.6021
PW @ 25% = -5920.435
PW @ 30 % = -22,641.9913
09-Oct-20 16
Sensitivity Analysis
For 5 floor building:
Using PW formulation, prime equation becomes
-2,00,000+ 37,815 (p/A, i%, N)+3,00,000(p/F, i%, N)
=-2,00,000+37,815* +3,00,000* ..(A)
Using interest rates from 5% to 30%;
PW @ 5% = 1,98,777.0102
PW @ 10% = 1,29,624.9986
PW @ 15% = 75,914.7656
PW @20% = 33,653.2696
PW @ 25% = -0.8768
PW @ 30 % = -27,100.2075
09-Oct-20 17
Sensitivity Analysis
Tabulating the result,
Floor 5% 10% 15% 20% 25% 30%
height/ PW
4 floor 1,17,905. 74,658.8 41,176.75 14,918.60 - -
1138 291 50 21 5,920.435 22641.991
3
5 Floor 1,98,777. 1,29,624. 75,914.76 33,653.26 -0.8768 -
0102 9986 56 96 27,100.20
75
09-Oct-20 18
Sensitivity Analysis
To be economical PW ≥ 0. finding i% when PW is ‘0’.
For 4 floor
PW i%
14,918.6021 20%
-5920.435 25%
0 ?
By interpolating the required value is 23.56%.
Therefore, 4 floor building is economical for a range
from 5% to 23.56% where pw is positive.
09-Oct-20 19
Sensitivity Analysis
Similarly,
For 5 floor
PW i%
33,653.2696 20%
-o.8768 25%
0 ?
By interpolating the required value is 24.99%.
Therefore, 5 floor building is economical for a range
from 5% to 24.99% where pw is positive.
09-Oct-20 20
Thank You
09-Oct-20 21