Advance Financial Accounting

Running head: ADVANCE FINANCIAL ACCOUNTING
Advance Financial Accounting
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1ADVANCE FINANCIAL ACCOUNTING
Table of Contents
Question 1:.......................................................................................................................................2
a) Explaining the concept of Sensitivity Analysis:..........................................................................2
b) Explaining the concept of Scenario analysis in capital budgeting process:................................3
Question 2: Calculating the net present value, IRR, Payback period, discounted payback period
and profitability index of the proposed project................................................................................5
References and Bibliography:..........................................................................................................8

2ADVANCE FINANCIAL ACCOUNTING
Question 1:
a) Explaining the concept of Sensitivity Analysis:
Sensitivity analysis is an adequate technique, which is used by the organisation for
analysing the critical variables of the project. The sensitivity method portrays the additional
analysis, which is needed by the organisation for evaluating the proposed project’s future
outcome before allowing the investment to be conducted. The sensitivity analysis is conducted
by altering the key assumptions of the capital project for detecting its performance in the long
run. The net present value of the project is an adequate investment appraisal technique, which is
derived from the net cash flows. The change in the variable factors of the NPV will directly alter
its value, which directly indicates that NPV sensitive to the variable factors. In addition, the
sensitivity of a capital budgeting project is analysed with the reference to the level of revenues,
operating margin, expected growth rate in revenues, and working capital requirements
(Borgonovo and Plischke 2016).
The sensitivity analysis directly allows the organisation to understand the impact of
changing variables on the viability of the project to deliver positive cash flows. Moreover, it
could be assumed that change in the selling price by 5% will alter the NPV by 10%, which
directly indicates that NPV is sensitive to change in selling price. Sensitivity analysis involves
certain steps, where adequate identification of the variables is needed for detecting the
quantitative relationship among the variables. Moreover, analysis on the impact of changes on
the NPV is detected to highlight the components, which can alter the value. Iooss and Lemaitre

3ADVANCE FINANCIAL ACCOUNTING
(2015) mentioned that with the help sensitivity analysis companies are able to understand the
level of alternations that can be made by the variable components of the project.
There are specific advantages and disadvantages of the sensitivity analysis, which can
help in detecting the financial viability of the project. The major advantage of sensitivity analysis
is the benefit it gives to the organisation in viewing a greater visibility to the weak spot in an
investment. This detection of the weakness mainly helps in understanding the level of
improvements that needs to be conducted for raising the performance of the proposed project.
The second advantage of sensitivity analysis is that it allows the management to critically
investigate factors that validate the assumptions of the project. Moreover, the sensitivity analysis
aids the management in making proper decision regarding commencement of the project (Ding
and VanderWeele 2016).
The major disadvantage of sensitivity analysis is that variable is often interdependent,
which make the examining of the components for each individually unrealistic. Moreover, the
sensitivity analysis is based on past data, which might not be effective in future. Furthermore, the
sensitivity analysis is open to subjective interpretation and risk preference, which is different for
each individual or the decision maker. Moreover, the sensitivity analysis method is not
considered as risk measuring or risk reducing technique. Hence, it could be understood that by
using the sensitivity analysis the organisation is not able to gather clear decision rule for the
investment (Pianosi, Sarrazin and Wagener 2015).
b) Explaining the concept of Scenario analysis in capital budgeting process:
The scenario analysis is an effective measure that allows the organisation to evaluate the
performance of the project under number of scenarios. The scenario analysis is considered to be