Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change.

Sensitivity analysis allows us to explore the effects of errors in our NPV estimates for the project.

By conducting sensitivity analysis, we learn which assumptions are the most important and we can then invest further resources and effort to refine these assumptions.

Such an analysis also reveals which aspects of the project are most critical when we are actually managing the project.

The underlying assumptions can be variable cost, fixed cost, sales volume, price, market share or size of the project.

Step 1 For conducting sensitivity analysis , we calculate the OCF ( Operating cash flow ) by Tax shield method or it is also known as the method of calculating free cash flow.

OCF = [(SP VC)Q FC](1 tc) + tcD

Step 2 : then find the change in NPV with unit of change in underlying assumptions i.e sales quantity dropped, prices are hiked , VC get changed etc.

Break-even analysis is another way to address uncertainty. The idea is to determine minimum levels of sales at which a project would break-even (in some sense).

The results can help the rm assess the likelihood that the project will fail (and thus a measure of the project's risk).

Common tool for analyzing the relationship between sales volume and profitability

There are three common break-even measures

Accounting break-even: sales volume at which net income = 0

Cash break-even: sales volume at which operating cash flow = 0

Financial break-even: sales volume at which net present value = 0

The accounting break-even point is the level of sales at which profits are zero or, equivalently, at which total revenues equal total costs.

The income statement looks like this:

Sales 2250

Variable costs 1350

Fixed costs 600

Depreciation 300

EBIT 0

Taxes 0

Net income 0

Formula for accounting break even point

ABEP : FC + DEP/ SP- VC

What is the level of sales that results in zero NPV?

Whereas the accounting and cash break-evens can be thought of as kinds of down-side bench-marks, the financial break-even is the target the project needs to hit to be worth und

Step 1 : find the EAC ( Equivalent Annual cost )

For that initial investment which divided into years, find the annual cost of that. i.e the annuity .

So PMT formula can be used by keeping initial investment as PV

Or apply the PVA formula of TVM

Present value of an annuity can be computed as : formula method

A (1 + i)n 1 i (1 + i)n

Table Method

A (PVIFA i, n)

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Now you have EAC with you.

Step 2 :

Find Q at which NPV = 0

0 = - EAC + OCF (r,n)

0= - EAC + [(SP VC)Q FC](1 tc) + tcD

0= -EAC + {(SP-VC) (1-tc) } * Q FC(1-tc) + tcD

Q = [EAC + FC(1-Tc)- tcD] /[(SP-VC) (1-Tc) ]

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