Page 6 - CIMA MCS Workbook November 2018 - Day 2 Suggested Solutions

CIMA NOVEMBER 2018 – MANAGEMENT CASE STUDY

The difference between the results of the two appraisals will indicate the overall risk levels
involved.

Apply more difficult targets

When performing investment appraisals, comparison will be made of the project results to a
target figure. In NPV calculations the target cost of capital is incorporated into the calculations
themselves. For other appraisal tools such as payback or accounting rate of return (ARR), an
arbitrary target is set by management.

Projects that meet or beat these targets are deemed to be acceptable. If we know that the
figures used in the appraisal are uncertain, one way of addressing this is to use a more difficult
target, so add a couple of percentage points onto the cost of capital figure used or target ARR
figure. Shorten the payback period. By making it more difficult for the projects to be accepted we
are automatically incorporating a bit of a buffer to deal with the uncertainty faced.

Sensitivity analysis

Once a project appraisal such as an NPV calculation has been done, we can do extra calculations
that allow us to identify figures critical to the success of the project. We could also, for instance,
increase all of our costs by 5% and look at how it affects the results, or reduce our sales volumes
by 10% and see the effects.

One way of using this sensitivity analysis is to look at a particular variable and calculate by how
much it would need to alter for us to change our minds about the decision to go ahead with the
project or not. Variables whose calculations produced a low sensitivity figure would be deemed
to be critical ones, as only small changes in these variables would affect the overall feasibility of
the project.

For instance, if it was found that there was a 10% sensitivity to the extra sales volumes generated
by the project and a 1% sensitivity to the material cost for the new packaging then our main
concern would be that it only needs a 1% increase in material costs compared to the numbers
we’ve predicted for the project to fail. We would then need to investigate this further, aiming to
either reduce the material cost or get more certainty about its potential cost.

Simulation

Simulation is sensitivity analysis done on a much larger scale, running the appraisal many times
with different combinations of variables included to get an idea of the pattern of overall potential
results.

Note that all of these techniques will allow better decisions to be made when uncertainty is
involved but none of them will give an absolute go or no‐go decision about the project. It will still
come down to a professional decision that does involve risk being taken on.

Finance Manager

96 KAPLAN PUBLISHING