UNIT III PROFITABILITY, INVESTMENT ALTERNATIVE AND

REPLACEMENT
3.1 Estimation of project profitability

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3.2 Sensitivity analysis
What is Sensitivity Analysis?

No matter how well-executed

executed or comprehensive an economic evaluation, the data on costs and
outcomes will inevitably contain various degrees of uncertainty and potential bias. Investigators
often make best estimates of unknown variables based on available information
information from experts and
the literature.

Sensitivity analyses are performed to test the robustness of study results and conclusions
when these underlying assumptions or estimates are varied. This process reveals the degree
of uncertainty, imprecision, or methodological controversy in the evaluation.

Examples of questions addressed in sensitivity analysis include the following:

• What if a discount rate of 6% was used instead of 2%?

• What if the compliance rate for influenza vaccination was 10% higher than originally
assumed?
• What if the per diem hospital cost underestimated the true economic cost of the health care
program by $100?
• What if indirect and intangible costs were not considered?

Steps in Sensitivity Analysis

If large variations in critical methodological assumptions or estimates produce significant changes

in study findings, then the evaluation cannot be viewed as definitive and should be interpreted with
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caution. Conversely, if large variations cause little change, then the evaluation can be considered
valid, despite a wide range of uncertainty for specific parameters.

The basic steps in performing a sensitivity analysis are outlined below:

Step 1 - Determine controversial estimates

Step 2 - Set bounds
Step 3 - Calculate results

Step 1

Determine which estimates are controversial. Estimates are subject to debate if

estimation procedures are known to be imprecise (e.g. hospital costs according to
per diem figures); if informed guesses are made (e.g. effectiveness of a new and as
yet unproved medical technology); and if there are potential differences in
methodology or value judgments (e.g. the choice of a discount rate).

Step 2

Set upper and lower bounds on the possible range of estimates by considering
empirical evidence from previous studies, by considering current practice as
described in the literature, and by soliciting judgments from those who will be making
decisions using the given economic evaluation.

Step 3

Calculate results according to the "best-guess," "most conservative," and "least

conservative" estimates of uncertain variables.

Sensitivity and Risk Analysis as a measure of Uncertainty :

Sensitivity analysis is a simple technique to assess the effects of adverse changes on a project.

It involves changing the value of one or more selected variables and calculating the resulting change in
the Net Present Value (NPV) or Incremental Rate of Return (IRR).

The extent of change in the selected variable to test can be derived from post evaluation and other
studies of similar projects.

Changes in variables can be assessed one at a time to identify the key variables. Possible combinations
can also be assessed.

APPLICATION OF SENSITIVITY ANALYSIS:

Sensitivity analysis should be applied to project items that are numerically large or for which there is
considerable uncertainty.

To facilitate mitigating action, variation should be applied separately to underlying variables, such as
areas and yields in agricultural projects, and not just to aggregate values.

The effects of variation in the basic parameters for shadow price analysis should also be assessed.

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PRESENTATION OF RESULTS:

The results of the sensitivity analysis should be summarized, where possible, in a sensitivity indicator
and in a switching value.

A sensitivity indicator compares the percentage change in a variable with the percentage change in a
measure of project worth. The preferred measure is the NPV.

A switching value identifies the percentage change in a variable for the NPV to become zero, the IRR to
fall to the cut-off rate, and the project decision to change.

Where percentage changes in the variable cannot be measured, for example, for delays, simply the
percentage change in the NPV can be presented.

MITIGATING ACTIONS:

Where the project is shown to be sensitive to the value of a variable that is uncertain, mitigating
actions should be considered.

This can include project level actions, such as long-term supply contracts or pilot phases; sector level
actions, such as price changes or technical assistance programs; or national level actions, such as
changes in tax and incentive policies.

Where there is exceptional uncertainty, the project may have to be redesigned or implemented first on
a pilot basis.

USES OF SENSITIVITY ANALYSIS:

Sensitivity and risk analysis can be used to assess the effects of changes in project variables that are
quantified.

The results can be presented together with recommendations on what actions to take or which
variables to monitor during implementation and operation.

However, many projects involve institutional and social risks that cannot be readily quantified. A
statement of such risks and any mitigating actions should be included alongside the conclusions
from the sensitivity and risk analysis.

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3.3 Investment alternatives

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3.4 Replacement policy

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3.5 Forecasting sales

Businesses are forced to look well ahead in order to plan their investments, launch
new products, and decide when to close or withdraw products and so on. The sales
forecasting process is a critical one for most businesses. Key decisions that are
derived from a sales forecast include:
- Employment levels required
- Promotional mix
- Investment in production capacity

TYPES OF FORECASTING

There are two major types of forecasting, which can be broadly described as macro
and micro:

Macro forecasting is concerned with forecasting markets in total. This is about

determining the existing level of Market Demand and considering what will happen
to market demand in the future.

Micro forecasting is concerned with detailed unit sales forecasts. This is about
determining a product’s market share in a particular industry and considering what
will happen to that market share in the future.

A common method of preparing a sales forecast has three steps:

(1) Prepare a macroeconomic forecast – what will happen to overall economic

activity in the relevant economies in which a product is to be sold.

(2) Prepare an industry sales forecast – what will happen to overall sales in an
industry based on the issues that influence the macroeconomic forecast;

(3) Prepare a company sales forecast – based on what management expect to

happen to the company’s market share

Sales forecasts can be based on three types of information:

(1) What customers say about their intentions to continue buying products in the
industry
(2) What customers are actually doing in the market
(3) What customers have done in the past in the market

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CREATING THE SALES FORECAST FOR A PRODUCT

The first stage in creating the sales forecast is to estimate Market Demand.

Definition:
Market Demand for a product is the total volume that would be bought by a defined
customer group, in a defined geographical area, in a defined time period, in a given
marketing environment. This is sometimes referred to as the Market Demand Curve.

Stage two in the forecast is to estimate Company Demand.

Company demand is the company’s share of market demand. This can be

expressed as a formula: Company Demand = Market Demand v Company’s Market
Share

A company’s share of market demand depends on how its products, services,

prices, brands and so on are perceived relative to the competitors. All other things
being equal, the company’s market share will depend on the size and effectiveness
of its marketing spending relative to competitors.

Stage three is then to develop the Sales Forecast.

The Sales Forecast is the expected level of company sales based on a chosen
marketing plan and an assumed marketing environment.

Obtaining information on existing market demand

As a starting point for estimating market demand, a company needs to know the
actual industry sales taking place in the market. This involves identifying its
competitors and estimating their sales.

An industry trade association will often collect and publish (sometime only to
members) total industry sales, although rarely listing individual company sales
separately. By using this information, each company can evaluate its performance
against the whole market.

This is an important piece of analysis. Say, for example, that Company A has sales
that are rising at 10% per year. However, it finds out that overall industry sales are
rising by 15% per year. This must mean that Company A is losing market share – its
relative standing in the industry.

Another way to estimate sales is to buy reports from a marketing research firms.
These are usually good sources of information for consumer markets – where retail

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sales can be tracked in great detail at the point of sale. Such sources are less useful
in industrial markets which usually rely on distributors.

Estimating Future Demand

So far we have identified how a company can determine the current position:
Current Company Demand = Current Market Demand x Current Market Share

How can future market demand and company demand be forecast?

Very few products or services lend themselves to easy forecasting . These tend to
involve a product whose absolute level or trend of sales is fairly constant and where
competition is either non-existent (e.g. monopolies such as public utilities) or stable
(pure oligopolies). In most markets, total demand and company demand are not
stable – which makes good sales forecasting a critical success factor.

Time Series Analysis

Many businesses prepare their sales forecast on the basis of past sales.
Time series analysis involves breaking past sales down into four components:

(1) The trend: are sales growing, “flat-lining” or in decline?

(2) Seasonal or cyclical factors. Sales are affected by swings in general economic
activity (e.g. increases in the disposable income of consumers may lead to increase
in sales for products in a particular industry). Seasonal and cyclical factors occur in
a regular pattern;

(3) Erratic events; these include strikes, fashion fads, war scares and other
disturbances to the market which need to be isolated from past sales data in order
to be able to identify the more normal pattern of sales

(4) Responses: the results of particular measures that have been taken to increase
sales (e.g. a major new advertising campaign)

Using time series analysis to prepare an effective sales forecast requires

management to:
• Smooth out the erratic factors (e.g. by using a moving average)
• Adjust for seasonal variation
• Identify and estimate the effect of specific marketing responses

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3.6 Inflation and its impact

What Is Inflation?

Inflation is defined as a sustained increase in the general level of prices for goods and services. It
is measured as an annual percentage increase. As inflation rises, every rupee you own buys a
smaller percentage of a good or service.

The value of a rupee does not stay constant when there is inflation. The value of a rupee is
observed in terms of purchasing power, which is the real, tangible goods that money can buy.
When inflation goes up, there is a decline in the purchasing power of money. For example, if the
inflation rate is 2% annually, then theoretically a Re.1 pack of gum will cost Rs.1.02 in a year. After
inflation, your rupee can't buy the same goods it could beforehand.

There are several variations on inflation:

• Deflation is when the general level of prices is falling. This is the opposite of inflation.
• Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown
of a nation's monetary system. One of the most notable examples of hyperinflation occurred
in Germany in 1923, when prices rose 2,500% in one month!
• Stagflation is the combination of high unemployment and economic stagnation with
inflation. This happened in industrialized countries during the 1970s, when a bad economy
was combined with raising oil prices.

In recent years, most developed countries have attempted to sustain an inflation rate of 2-3%.

Causes of Inflation
There is no one cause that's universally agreed upon, but at least two theories are generally
accepted:

Demand-Pull Inflation - This theory can be summarized as "too much money chasing too few
goods". In other words, if demand is growing faster than supply, prices will increase. This usually
occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to increase prices to maintain their
profit margins. Increased costs can include things such as wages, taxes, or increased costs of
imports.

Impacts of Inflation
Inflation affects different people in different ways. It also depends on whether inflation is
anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are
expecting (anticipated inflation), then we can compensate and the cost isn't high. For example,
banks can vary their interest rates and workers can negotiate contracts that include automatic
wage hikes as the price level goes up.

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Problems arise when there is unanticipated inflation:

• Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For
those who borrow, this is similar to getting an interest-free loan.
• Uncertainty about what will happen next makes corporations and consumers less likely to
spend. This hurts economic output in the long run.
• People living off a fixed-income, such as retirees, see a decline in their purchasing power
and, consequently, their standard of living.
• The entire economy must absorb repricing costs ("menu costs") as price lists, labels,
menus and more have to be updated.
• If the inflation rate is greater than that of other countries, domestic products become less
competitive.

People like to complain about prices going up, but they often ignore the fact that wages should be
rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a
quicker pace than your wages.

Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even
deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the
economy is weakening. As you can see, it's not so easy to label inflation as either good or bad - it
depends on the overall economy as well as one’s personal situation.

Contrary to popular belief, excessive economic growth can in fact be very detrimental. At one
extreme, an economy that is growing too fast can experience hyperinflation, resulting in the
problems we mentioned earlier. At the other extreme, an economy with no inflation has essentially
stagnated. The right level of economic growth, and thus inflation, is somewhere in the middle. It's
the Govt's job to maintain that delicate balance. A tightening, or rate increase, attempts to head off
future inflation. An easing, or rate decrease, aims to spur on economic growth.

Inflation And it impacts on Investments

When it comes to inflation, the question on many investors' minds is: "How will it affect my
investments?" This is an especially important issue for people living on a fixed income, such as
retirees.

The impact of inflation on one’s portfolio depends on the type of securities one hold. If one invests
only in stocks, there is no need of worrying about inflation.
Over the long run, a company's revenue and earnings should increase at the same pace as
inflation. The exception to this is stagflation. The combination of a bad economy with an increase
in costs is bad for stocks. Also, a company is in the same situation as a normal consumer - the
more cash it carries, the more its purchasing power decreases with increases in inflation.

The main problem with stocks and inflation is that a company's returns tend to be overstated. In
times of high inflation, a company may look like it's prospering, when really inflation is the reason
behind the growth. When analyzing financial statements, it's also important to remember that
inflation can wreak havoc on earnings depending on what technique the company is using to value
inventory.

Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested

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Rs.1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the Rs.1,100 owed
to you, is your Rs.100 (10%) return real? Of course not! Assuming inflation was positive for the
year, your purchasing power has fallen and, therefore, so has your real return. We have to take
into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is
really 6%.

This example highlights the difference between nominal interest rates and real interest rates. The
nominal interest rate is the growth rate of your money, while the real interest rate is the growth of
your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the
rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).

Inflation: How Is It Measured?

There are two main price indexes that measure inflation:

• Consumer Price Index (CPI) - A measure of price changes in

consumer goods and services such as gasoline, food, clothing
and automobiles. The CPI measures price change from the
perspective of the purchaser.

• Producer Price Indexes (PPI) - A family of indexes that measure

the average change over time in selling prices by domestic
producers of goods and services. PPIs measure price change
from the perspective of the seller.

Summary
Inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends
on one’s personal situation.

To summarize:

• Inflation is a sustained increase in the general level of prices for goods and services.
• When inflation goes up, there is a decline in the purchasing power of money.
• Variations on inflation include deflation, hyperinflation and stagflation.
• Two theories as to the cause of inflation are demand-pull inflation and cost-push inflation.
• When there is unanticipated inflation, creditors lose, people on a fixed-income lose, "menu
costs" go up, uncertainty reduces spending and exporters aren't as competitive.
• Lack of inflation (or deflation) is not necessarily a good thing.
• Inflation is measured with a price index.
• The two main groups of price indexes that measure inflation are the Consumer Price Index
and the Producer Price Indexes.
• In the long term, stocks are good protection against inflation.
• Inflation is a serious problem for fixed income investors. It's important to understand the
difference between nominal interest rates and real interest rates.
• Inflation-indexed securities offer protection against inflation but offer low returns.

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 PART-B Q & A WITH ANSWERS IN PAGE NUMBERS:

1. How will you measure profitability of an industry? Explain the different

methodologies with suitable examples? Page 1-5
2. Problem on Profitability estimation using any one or two of the available 4 methods.
Page 1-5
3. What is sensitivity analysis? Enumerate the steps and usefulness. Page 5-7
4. Problem on choosing the best alternative among many designs or equipments using
IRR method. Page 8-12
5. Discuss in detail the replacement policy? Derive an expression for replacement of
equipment that deteriorates with time. Page 13-16
6. Problem on finding the best period (year) of replacing an existing equipment at
which the total cost is minimum. Page 17-19
7. Write a note on sales forecasting? How will you create a real sales forecast for a
product? Page 20-22
8. What is inflation? Elaborate its causes and impact on different people? How can you
measure and control it? Page 23-25

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