Sensitivity analysis may be used to assess the risk associated with a capital investment project

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journal article

A Statistical Analysis of Risk in Capital Investment Projects

OR

Vol. 18, No. 1 (Mar., 1967)

, pp. 13-33 (21 pages)

Published By: Operational Research Society

https://doi.org/10.2307/3010766

https://www.jstor.org/stable/3010766

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Abstract

The object of this paper is twofold: first, to present a brief survey of the various techniques used in the measurement of risk in capital investment proposals; second, to show how, under certain assumptions, the probability distributions of the two most commonly used profitability criterion functions, viz. Net Present Value and Internal Rate of Return, can be obtained. This approach was first presented by Hillier in a paper published in Management Science for the single investment case. It was further generalized by him to the case of interrelated investments in an outstanding paper published in July 1964 as Technical Report No. 73 under contract with the office of Naval Research. These papers are theoretically oriented. The present paper discusses Hillier's approach and considers some numerical examples showing how the approach can be implemented in practice. Secondly, the starting point of Hillier's analysis are the means and variances of cash flows. In many situations these may not be known directly. What may be available are the means and variances of factors which make up these cash flows. The present paper discusses methods for handling such situations.

Publisher Information

The Operational Research Society, usually known as The OR Society, is a British educational charity. Originally established in 1948 as the OR Club, it is the world's longest established body in the field, with 3000 members worldwide. Practitioners of Operational Research (OR) provide advice on complex issues to decision makers in all walks of life, arriving at their recommendations through the application of a wide variety of analytical methods. The Society's aims are to advance education and knowledge in OR, which it does through the publication of journals, the holding of conferences and meetings, the provision of training courses, and the organisation and support of study (special interest) groups and regional groups. In recent years the Society has made extensive use of internet technologies to facilitate the discovery and exchange of information by its members.

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  • 1 Sensitivity Analysis
    • 1.1 Illustration
    • 1.2 Strengths of sensitivity analysis
    • 1.3 Weaknesses of sensitivity analysis

Sensitivity Analysis

Sensitivity analysis in a method used to incorporate uncertainty into decision making by taking each uncertain factor in turn, and calculates the change that would be necessary in that factor before the original decision is reversed. Typically, it involves posing 'what-if' questions.

By using this technique it is possible to establish which estimates (variables) are more critical than others in affecting a decision.

The process is as follows:

  • Best estimates for variables are made and a decision arrived at.
  • Each of the variables is analysed in turn to see how much the original estimate can change before the original decision is reversed. For example, it may be that the estimated selling price can fall by 5% before the original decision to accept a project is reversed.
  • Estimates for each variable can then be reconsidered to assess the likelihood of the estimate being wrong. For example, what is the chance of the selling price falling by more than 5%?
  • The maximum possible change is often expressed as a percentage. This formula only works for total cash flows. It cannot be used for individual units, selling prices, variable cost per unit, etc.

Illustration

A manager is considering a make v buy decision based on the following estimates:

Sensitivity analysis may be used to assess the risk associated with a capital investment project

You are required to assess the sensitivity of the decision to the external purchase price.

Step 1: What is the original decision?

Comparing contribution figures, the product should be bought in and re-badged:

Sensitivity analysis may be used to assess the risk associated with a capital investment project

Step 2: Calculate the sensitivity (to the external purchase price)

For indifference, the contribution from outsourcing needs to fall to $5 per unit. Thus the external purchase price only needs to increase by $1 per unit (or $1/ $6 = 17%). If the external purchase price rose by more than 17% the original decision would be reversed.

Strengths of sensitivity analysis

  • There is no complicated theory to understand.
  • Information will be presented to management in a form which facilitates subjective judgement to decide the likelihood of the various possible outcomes considered.
  • It identifies areas which are crucial to the success of the project. If the project is chosen, those areas can be carefully monitored.

Weaknesses of sensitivity analysis

  • It assumes that changes to variables can be made independently, e.g. material prices will change independently of other variables. Simulation allows us to change more than one variable at a time.
  • It only identifies how far a variable needs to change; it does not look at the probability of such a change.
  • It provides information on the basis of which decisions can be made but it does not point to the correct decision directly.

Sensitivity analysis may be used to assess the risk associated with a capital investment project

Created at 6/1/2012 3:22 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 9/26/2013 2:35 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

Sensitivity analysis may be used to assess the risk associated with a capital investment project

Sensitivity analysis may be used to assess the risk associated with a capital investment project

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Sensitivity analysis may be used to assess the risk associated with a capital investment project

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Sensitivity analysis may be used to assess the risk associated with a capital investment project

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What is capital investment analysis?

Capital investment analysis is a budgeting procedure that companies and government agencies use to assess the potential profitability of a long-term investment. Capital investment analysis assesses long-term investments, which might include fixed assets such as equipment, machinery, or real estate.

Why risk analysis is important in capital budgeting?

Risk analysis supports the investment decision by giving the investor a measure of the variance associated with an investment appraisal return estimate. Probabilistic method is not a substitute of Deterministic method but rather a tool that enhances its results.

What are the risk involved in capital budgeting?

Risk in capital budgeting has three levels: the project's stand-alone risk, its contribution- to-firm risk, and systematic risk. Stand-alone risk measures a project's potential without factoring in the potential risk that it adds to the company's assets and other projects.

Which of the following statistical or mathematical technique of risk evaluation is used in capital budgeting?

For Capital Budgeting decisions, Standard Deviation is used to calculate the risk associated with the estimated cash flows from the project.