Page 9 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 20.d: Explain how sensitivity analysis, scenario analysis,
and Monte Carlo simulation can be used to assess the stand- READING 20: CAPITAL BUDGETING
alone risk of a capital project.

Sensitivity analysis involves changing an input (independent) variable to MODULE 20.2: EVALUATION OF PROJECTS AND DISCOUNT RATE ESTIMATION
see how sensitive the dependent variable is to the input variable.

EXAMPLE: Sensitivity Scenario analysis considers both the sensitivity of some
analysis: Ferndale Inc. is key output variable (e.g., NPV) to changes in a key input
analyzing a capital budgeting variable (e.g., sales) and the likely probability distribution of
expansion project with the these variables. Scenario analysis allows for changes in
following cash flow forecasts: multiple input variables all at once (worst case, best case, and
• 3-year project base case) whilst sensitivity only allows for one scenario!
• Unit sales = 1,500 per year
• Price = $50.00
• Variable cost = $20.00 per unit
• Fixed cost = $5,000 per year
• FCInv = $60,000
• Depreciated straight-line over
three years to book value of
zero
• NWCInv = $15,000
• Salvage value at end of three
years = $10,000 To which inputs are the NPV and the IRR estimates (1)
• Marginal tax rate = 40% most sensitive and (2) least sensitive?
• Cost of capital = 15%
Answer: The project’s NPV and IRR are most sensitive to changes
The base case NPV and IRR are in price because when price drops by 20% the NPV goes from
$11,871 and 23.5%, respectively. positive to negative. The project is also sensitive to changes in unit
sales because a 20% drop in sales will generate a negative NPV.
The following figure includes a The project appears to be least sensitive to changes in the estimate
sensitivity analysis of the key of salvage value and fixed costs.
inputs assuming a 20% increase
and decrease in each variable,
holding the others constant. (We
haven’t provided the solutions
here because we want to focus on
sensitivity analysis, but feel free to
check our answers!)