5. Sensitivity and scenario analysis Different techniques for analyzing project

Question

5. Sensitivity and scenario analysis Different techniques for analyzing project risk require different input variables and assumptions. Suppose you are using the scenario analysis technique to evaluate project risk. You would change several input variables together in the model to evaluate the effect of the input factors on the expected value. Ell is a risk analyst. She is conducting a sensitvity analysis to evaluate the riskiness of a new company is considering investing in. Her risk analysis report includes the sensitivity curve shown on the graph. NPV (Millions of dollars Base Case NPV IBase Case Cost of Capital 15 COST OF CAPITAL (Percent) This curve implies that the project is not very sensitive to changes in cost of capital. The project's NPV is likely to if the cost of capital increases to 15%. stay positive become negative

Explanation / Answer

Question 1: The curve implies that the project is not very sensitive to changes in cost of capital. The project's NPV is likely to stay positive if the cost of capital increases to 15%.

Looking at the graph, you can see when you extend the line of graph it won't touch x-axis at 15%, which means NPV would not be zero at 15% and would stay above zero (i.e., positive).

Question 2

Expected NPV = probability weighted average NPVs for 3 scenarios = (0.35 * -5.62) + (0.30 * 7.94) + (0.35 * 16.45) = -1.967 + 2.382 + 5.7575 = 6.1725

Now, in order to calculate the standard deviation (which is the square root of variance, we will first calculated the variance. Variance is the sum of probability weighted squared deviations of individual NPV values from expected NPV value.

Variance = 0.35 * (-5.62 - 6.1725)2 + 0.30 * (7.94 - 6.1725)2 + 0.35 * (16.45 - 6.1725)2  

Variance = 86.5787

Standard deviation = square root (86.5787)

Standard deviation = 9.3047

Standard deviation = 9.30

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