Desktop version

Home arrow Business & Finance arrow Executive finance and strategy

< Prev   CONTENTS   Next >

How much analysis should be carried out?

What is meant by 'sensitive' - what levels of sensitivity can be tolerated?

The simple answer would be: none. However, there are probably obvious truths: small, adverse changes in the largest parameters will inevitably have the greatest effect as to whether there is a positive NPV and whether the project is viable. Another 'truth' from the arithmetic is that the largest amount, over the life of the project, has to be the total of inflows; the present value of all inflows has to equal or exceed the present value of all capital and operational outflows, and thus we arrive at the not surprising conclusion that inflows, income or revenue will be sensitive possibly even to small changes.

One way of considering sensitivities and thus response is to band sensitivities as follows:

- % increase in costs before zero NPV - 100% change is a doubling of costs before zero NPV:

- 100%+ adverse change: tolerable - presumably no problem.

- 100-50% adverse change: presumably tolerable - parameters whose sensitivity fell within this range should be reviewed -how material is the parameter? What can be done to ensure that a 50+% adverse change never occurs?

- 50-20% adverse change: tolerable if managed - any parameter whose sensitivity falls within this range must be reviewed and demonstrable action taken to limit any change from the most likely figure.

- 20% or less adverse change: not tolerable - if the investment was one of many purely speculative investments, the simple answer would be 'walk away'. However, investment has to be made and will be part of the wider strategic plans of a business. If a parameter is 20% or less tolerable to change, it really must be tied down in amount or some compensating parameter/action sought to mitigate any adverse changes.

- % decrease in income before zero NPV - a 50% fall is a halving of income before zero NPV:

- 50% + adverse change - tolerable - eg if income were to be 90% less than budget and the project was still viable then presumably there would be no problem?

- 50%-20% change tolerable - eg if a fall in income of 20% meant zero NPV then the (and I'd say up to 50%) potential for this occurrence must be reviewed and demonstrable action taken to limit any change from the most likely figure.

- 20% or less change tolerable - if the investment was one of many purely speculative investments then the simple answer would be 'walk away'. However, investment has to be made and will be part of the wider strategic plans of a business. If a parameter is 20% or less tolerable to change, it really must be tied down in amount or some compensating parameter/action sought to mitigate any adverse changes.

The limits of the 'one at a time' approach can be overcome by carrying out a most-likely sensitivity analysis. Also, if parameters are likely to change adversely in concert, this should be tested.

Note that it is sensible to have a company's specific views or guidelines on sensitivity incorporated in the appraisal process. To many people, the simple truths of economics arising from arithmetical relationships are not always self-evident. Spreadsheets are an excellent way of demonstrating and testing the simple but important relationships.

 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >

Related topics