Sensitivity Analysis
1. Project cost = Rs 1,20,000
Annual Cash inflow = Rs. 40,000
Project period = 5 years
Expected Rate of Return = 10%
Calculate NPV.
Also calculate NPV under following situations:
a) If Project cost Increases by 20%
b) If Annual Cash flow decreases by 20%
c) If Project period decrease by 20%
d) If Expected rate of return increases by 20%
2. A company has two mutually exclusive projects. The management has developed the
following estimates of the annual cash flows for which projects having a life of 10
years and 12% discount rate.
Project X (Rs) Project Y (Rs)
Net Investment 1,00,000 1,00,000
Annual CFAT
Pessimistic 12,000 15,000
Most Likely 17,000 17,000
Optimistic 20,000 19,000
Compute NPV using sensitivity analysis and comment
3. Panipat Ltd. has two mutually exclusive projects. The management estimates of both
the projects are given below.
Project M (Rs) Project N (Rs)
Net Investment 1,20,000 1,20,000
Cash Inflows:
Pessimistic 8,000 15,925
Most Likely 16,000 16,000
Optimistic 28,000 18,000
Calculate the NPV related with each estimate for both the projects. The projects have
a life of 12 years each and the company’s cost of capital is 8%. State giving reasons
which project should be selected.
Scenario Analysis
- Although Sensitivity analysis is probably the most widely used risk analysis
technique, it does have limitations.
- Therefore, we need to extend sensitivity analysis to deal with the probability
distributions of the inputs.
- In addition, it would be useful to vary more than one variable at a time so we could
see the combined effect of change in the variables.
- This analysis begins with base case or most likely set of values of the input variables.
- Then, go for worst case scenario (low unit sales, low sale price, high variable cost and
so on) and best-case scenario.
- So, in nutshell, Scenario analysis examines the risk of investments to analyse the
impact of alternative combinations of variables, on the project’s NPV.
1. The following date has been supplied to you
Life of the project 6 years
Cost of Project Rs. 35,00,000
Annual Cash flows Rs. 12,00,000 p.a.
Discounting Rate (Expected Rate of Return) 10%
Determine the NPV of the project under the following scenarios and Aggregate NPV.
a. All variables remain unchanged – Best Case Scenario – Probability 10%
b. Increase in initial project cost by 20%, life of project remains same, decrease in
annual case inflows by 10% and increase in cost of capital from 10% to 12% -
Most-Likely Case Scenario – Probability 70%
c. Increase in initial project cost by 20%, decrease in life of project to 5 years,
decrease in annual cash inflows by 20% and increase in cost of capital from 10%
to 12% - Worst Case Scenario. – Probability 20%
Replacement of Asset (Capital Budgeting)