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Sensitivity Analysis in Capital Investment Decision Making

IP.com Disclosure Number: IPCOM000082309D
Original Publication Date: 1974-Nov-01
Included in the Prior Art Database: 2005-Feb-28
Document File: 6 page(s) / 41K

Publishing Venue

IBM

Related People

Bischeri, G: AUTHOR

Abstract

For the purpose of making an economic/financial evaluation of a project for investment, breaking down the analysis into its characteristic elements: A - the sums invested, B - depreciation, C - investment resale values, D - operating expenses and incomes, and E - one-time taxes and reliefs from tax (or of any other nature), it is possible to treat the problem in general terms so that the features of each element can be observed, and the project can be reassembled at a later stage.

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Sensitivity Analysis in Capital Investment Decision Making

For the purpose of making an economic/financial evaluation of a project for investment, breaking down the analysis into its characteristic elements: A - the sums invested,
B - depreciation,
C - investment resale values,
D - operating expenses and incomes, and E - one-time taxes and reliefs from tax (or of any other nature), it is possible to treat the problem in general terms so that the features of each element can be observed, and the project can be reassembled at a later stage.

In this way, each one of the items listed above may be manoeuvred at will so that, leaving aside the others, it is possible to regard this item as an unknown of the problem and determine its value according to a predetermined rate of return.

The purpose of the sensitivity analysis is to highlight the extent to which the "x" rate of return is sensitive to the variations in individual forecasts, on which calculation of the economic advantages is based.

Determination of the profitability of the project.

Using the DCF (Discounted Cash Flow) method, profitability is the root of the equations:

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Any change in the total amounts invested also has a direct impact on V(x) (since, by altering the taxable plus-value calculated in (3), the present value of the resale values net of taxes is also altered) and, of course, also on D(x).

In order to carry out the sensitivity analysis of the profitability rate of the project following variations in the values to be invested, a new objective profitability, x1, is set, and the new value A(x1), which assumes (1), calculated.

Taking the interdependence relations into account, the variation delta I(x1) to zero A(x1) has to be found.

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Variations in the investment resale values.

Variations in the present value of the proceeds, net of taxes, of resale of fixed assets have no interrelations with other elements. Therefore: (8) delta V(x1) = - A(x1) which is used to calculate by how much the investment return value should vary, net of taxes and discounted, so that the project will have an intrinsic profitability rate equivalent to X1.

However, it is more interesting to know the variations required in the gross proceeds of the sale, not discounted and before taxes. The ratio is: (9) R(x1) = - A(x1) over (1-t) . (1+x1)/-n/ where: R(x1) = gross investment resale value

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required to obtain a profitability equivalent to X1. Variations in operating expenses and incomes.

The variations in the project expenses and incomes have no interrelations with other elements.

The relation between the present value of the project at the predetermined rate and the present value, net of taxes, of all the expenses and incomes is: (10) delta S(x1) = -A(x1). Variations in taxes and one-time tax reliefs.

The variations in taxes and one-time tax reliefs have no interrelations with other elements.

The relation between the present value of the project at the predeter...