CHAPTER 8

SENSITIVITY AND BREAKEVEN ANALYSIS

SOLUTIONS TO REVIEW QUESTIONS

QUESTIONS
8.1 Define and discuss the following terms:
 sensitivity analysis
 break-even analysis
 base-case solution
 optimistic and pessimistic forecasts
 ex ante and ex post management decision making.

8.2 Pacific Products Inc. is considering the introduction of a new product, Alpha. The
firm has gathered the following information relevant to the project:
 Initial fixed capital outlay: $120,000
 Initial working capital outlay: $9,800
 Life of the project: 5 years
 Capital recovery at project end: fixed $18,000; working $7,200
 Sales units forecast: 50,000 units in year one, growing at 6.00 % per annum
thereafter
 Unit selling price: $2.75
 Unit production cost: $1.28
 Annual fixed overhead cost: $35,000
 Annual tax rate of depreciation claimable: 20%per annum
 Annual income tax rate: 38%
 Required rate of return: 9 %pa
For these data:
(a) Calculate an NPV for the project under the given base-case scenario
(b) Perform sensitivity analyses on the following variables: initial fixed capital outlay,
unit selling price, annual sales growth rate, unit production cost.
(c) By the use of Data Tables and appropriate graphs, calculate the break-even points
for unit production cost and the required rate of return.
(d) Advise management of the analyses regarding the new product Alpha, and make
appropriate investment recommendations.
8.3 Compare and contrast sensitivity and break-even analyses with other risk analysis
methods such as the risk adjusted discount rate and the certainty equivalent
approach. Describe how each of these methods might influence management
decision-making.
ANSWERS
Answer to Q 8.1
Sensitivity analysis: This deals with the discovery of those variables which could cause
significant impacts on a project’s NPV. This analysis is usually done by stepping each
variable through its pessimistic, most likely and optimistic values.
This is a mechanical process of investigating the riskiness of a project, by allowing
variables, which give rise to cash flows, to take on expected high and low extreme values.
It is not based on any theoretical understanding of ‘risk’ or on any theoretical framework
of how risk and return are related. It is purely a mechanical method of measuring ‘what-
if’ impacts on a project’s NPV. In that sense it gives management answers to direct
intuitive questions, and can show various future scenarios.
It is not a simultaneous analysis, because only one variable is stepped at a time, whilst
others are held at their most likely values. The selection of variables is at best an
experientially guided process, and not based on any theoretical or conceptual groundings.
Therefore it cannot be guaranteed to capture or recognise important variables.
Break-even analysis: This deals with the discovery of the particular value of a particular
variable at which the project’s NPV becomes zero.
Break-even analysis is a special case of sensitivity analysis. It gives the lowest value to
which any variable can fall independently before the project has to be abandoned. It is a
useful figure when the firm may be engaged in a price war, a cost cutting exercise or a
declining market. It presupposes a rather pessimistic outlook fore the firm, but it does
give management a base line from which performance can only improve.
The numerical value of the actual break-even point can be calculated by substituting
various values by trial and error or using Excel’s Goal Seek function.
Base-case solution: Base-case values are calculated by setting all forecast variables at
their basic values which maybe their most likely values.
When only a single NPV is calculated that value is normally taken as the base-case
solution. Under the assumption of certainty, this is the only solution. However, when the
project is analysed under uncertainty the base-case solution is used as a starting point for
sensitivity analysis and break-even analysis. Alternative scenarios (e.g. optimistic and
pessimistic values) are prepared by making adjustments to the base-case variable values.
In our terminology, the ‘base-case’ is used to describe the basic calculated outcome or
solution. This may be different to the ‘most-likely’ values defined in the discipline of
statistics.
Optimistic and pessimistic forecasts: These refer to the upper and lower extreme values
of the forecasts.
Optimistic and pessimistic values can be generated using ad hoc approach (i.e. making
arbitrary adjustments to the base-case or most-likely values) or forecasting approach (i.e.
making appropriate adjustments on the basis of estimation errors associated with the
forecasting technique used or reasonable judgments by the management). If the ad hoc
approach is used in sensitivity analysis, then the result will be difficult to interpret and
will be unreliable.
Ex-ante and ex-post management decision-making: Ex-ante decisions are made before
a commitment is made to a project. Ex-post decisions are made after the project is
commenced and are concerned with the day-to-day monitoring of the project.
Sensitivity analysis can identify, ex-ante, the critical variables which would require ex-
ante decisions or ex-post decisions. For example, ex-ante decisions would be to get better
forecasts for some critical variables, to call new tenders for the capital expenditures,
adoption of cost reduction strategies or changing the scale of production to reduce the
cost. All of these decisions are taken before the project is commenced.
Once the project has begun operating, managers make ex-post decisions to ensure that
important (or sensitive) variables are properly monitored to keep the project viable.
Answer to Q 8.2
The base-case solution for new product Alpha is held in Excel file titled ‘Q 8.2 Excel
Solutions.xls’.
(a) The NPV result for the base-case is $27,715.
(b) There is no guidance in the question on how set up the optimistic and pessimistic
variations around the given base-case values. For demonstration purposes the
following set of forecasts has been assumed for the analysis.

Table Q 8.2: Pessimistic, base-case, and optimistic forecasts

for variables to be analysed.
Pessimistic Base-case Optimistic
Initial Outlay $150,000 $120,000 $100,000
Unit Selling
Price $2.00 $2.75 $3.10
Annual Sales
Growth Rate 2.00% 6.00% 9.00%
Unit Production
Cost $1.92 $1.28 $0.64

The outcomes of this analysis are given below:

Table Q 8.2: Results of sensitivity analysis
Variable Sheet Number Pessimistic NPV Optimistic NPV Range
Initial Outlay 1(2),1(3) $6,583 $41, 803 $35,220
Forecast Unit
Selling Prices 1(4),1(5) $(99,406) $72,969 $172,375
Annual Sales
Growth Rate 1(6),1(7) $19,062 $34,493 $15,431
Forecast Unit
Production Cost 1(8),1(9) $(76,466) $110,465 $186,931

A rank ordering of the critical variables is:

1 Forecast Production Cost per Unit
2 Forecast Selling Price per Unit
3 Initial Outlay.

The impact of changes in these variables is quite significant on the project’s NPV.
Management would be well advised to investigate the possible behavior of these
variables before proceeding with the project, perhaps by simulating them.

(c) From worksheet 1(10) the break-even production cost is between $1.74 and $1.75
per unit. From worksheet 1(11) the break-even required rate of return is 16.2%. This
figure is accurately calculated from the IRR within this worksheet, and it can be read
off the graph within the worksheet.

(d) Under the most likely scenario, the new product would be a sound investment. It is
possible that the internal aspects of production cost control could be reviewed ex-
ante, and controlled ex-post, so this variable would not cause a negative NPV.
Fortunately however the cost has to increase about 36% before the project becomes
untenable.
Variations in selling price may be more damaging to the project. The quoted price
range shows a plus variation of 12.7% and a minus variation of 27%. This relatively
low range has a large impact on the project’s NPV. The break-even price is calculated,
as an extra piece of decision-making information, at $2.54. This is only 7.6% below
the forecast price of $2.75. A price fall of this size is easily possible, so management
needs to develop better forecasts of this variable, or to ensure that it is controllable in
the market place.
With pessimistic forecasts, both of these variables result in a negative NPV for the
project, so careful management control will be needed.
The initial outlay size is also a significant variable, but even under a worst-case
forecast it still returns a positive NPV.
Answer to Q 8.3
Risk analysis methods compared
The capital budgeting decision inherently includes risk. Since investment decisions
represent long-term fund commitments, require long-term forecasts, and often deal
with unknown or un-proven products, they intrinsically require an appreciation of
variation in future values and a conversion of those future variations to today’s
decision variable, the NPV. There are several methods by which the risk associated
with unexpected variations to the cash flows can be analysed. Two such methods are
risk-adjusted discount rate and certainty equivalent.
The risk-adjusted discount rate attempts to incorporate the risk by making
adjustments to the denominator of the NPV formula, namely, by adjusting the
discount rate. Certainty equivalent method attempts to incorporate the risk by making
adjustments to the numerator of the NPV formula, namely, by directly adjusting the
values of the cash flows.
Both these methods eventually produce a single NPV. Sensitivity analysis produce a
range of NPVs. Break-even analysis produce the critical values at which the NPV will
be zero for a set of selected variables.
The Sensitivity and break-even approaches give management a better feel for the
behavior of individual variables and can identify which variables have to carefully
forecast and/or monitored by management. However, both these methods analyse the
behavior of only one variable at a time and may not capture all the risks of future
economic scenarios. More dynamic models such as simulations which capture the
behavior of all variables within the one analysis are examined in chapters nine and
ten.
All these methods can be used by the management for their decision support.