Assessing Risk and Sensitivity analysis

A very popular method of assessing risk, sensitivity analysis has certain merits:

* It shows how robust or vulnerable a project is to changes in values of the underlying variables.

* It indicates where further work may be done. If the net present value is highly sensitive to changes in some factor, it may be worthwhile to explore how the variability of that critical factor may be contained.

* It is intuitively very appealing as it articulates the concerns that project evaluators normally have.

Not withstanding its appeal and popularity, sensitivity analysis suffers from several shortcomings:

1. It merely shows what happens to NPV (Net Present Value) when there is a change in some variable, without providing any idea of how likely that change will be.
2. Typically, in sensitivity analysis only one variable is changed at a time. In real world, however, variables tend to move together.
3. It is inherently a very subjective analysis. The same sensitivity analysis may lead one decision maker to accept the project while another may reject it.

Break even Analysis: In sensitivity analysis, we ask what will happen to the project if sales decline or costs increase or something else happens. As a project analyst, you will also be interested to know how much the project does not lose money. Such an exercise is called break even the break even point. To figure out how the break even quantity is calculated, let us look at the flour mill project for which following estimates were obtained:

Sales Rs 18 million
Variable costs 12 million
Fixed costs 1 million
Depreciation 2 million

Note that the ratio of variable costs to sales is 0.667 (12 / 18). This means that every rupee of sales makes a contribution of Rs 0.333. Put differently, the contribution margin ratio is 0.333 hence the break even level of sales wile be:

Fixed cost + Depreciation/ Contribution margin ratio

= 1 + 2 / 0.333 = Rs 9 million.

By way of confirmation you can verify that the break even level of sales is indeed Rs 9 million.

Rs in million

Sales 9
Variable costs 6
Fixed costs 1
Depreciation 2
Profit before tax 0
Tax 0
Profit after 0

Adjustment of Risk: Given the information on the risk characteristics of the project, measured in whatever way, you have to adjust for risk. You may do it by adjusting the discount rate, or the cash flows, or the payback period.