Project Appraisal: Sensitivity and Break-even Analysis Report

This report delves into sensitivity analysis and break-even analysis within the context of project appraisal, essential tools for evaluating investment viability. It defines sensitivity analysis, outlining its procedures and applications, including the development of optimistic and pessimistic forecasts. The report emphasizes the importance of assessing the impact of changes in key variables, such as selling price, sales volume, and costs, on a project's Net Present Value (NPV) and Internal Rate of Return (IRR). It details the purpose of sensitivity analysis, which is to identify critical variables, investigate the consequences of adverse changes, and mitigate potential risks. The report also covers the procedures involved in sensitivity analysis, including identifying key variables, calculating the effects of changes, and analyzing the results using sensitivity indicators and switching values. A case study involving Bishoftu Automotive Engineering Industry (BAEI) is used to illustrate the application of sensitivity analysis, demonstrating how to measure project sensitivity to changes in investment costs, economic benefits, and operational costs. The report provides a comprehensive understanding of how sensitivity and break-even analyses are used to make informed financial decisions.

Project Identi cation....
Chala D (PhD)
RVU
September, 2021
Project Identication and
Appraisal
4. Sensitivity and Break-even Analysis
Sensitivity Analysis
Break-even Analysis

Project Identi cation....
Sensitivity Analysis
Sensitivity Analysis Demand
Procedures in Sensitivity Analysis
Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Break-even Analysis
Break-even analysis and decision-making
Sensitivity Analysis
Break-even Analysis
Table of Contents
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Project Identi cation....
Sensitivity Analysis
Break-even Analysis
Project Appraisal and Risk Techniques

Sensitivity Analysis De ned
Procedures in Sensitivity Analysis
Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Sensitivity Analysis
Break-even Analysis
Sensitivity Analysis Defined
chala Project Identi cation....
The financial and socio-economic analysis of investment
projects discussed in chapter 2is based on forecast of
quantifiable variables.
The values of these variables are
Estimated based on the most probable forecasts.
Influenced by a great number of factors and the actual
values may differ considerably from the forecasted values.
It is therefore useful to consider the effects of likely changes
in the key variables on the viability of the project.
We can do this performing sensitivity analysis.
The viability of projects is evaluated based on a comparison of
its NPV (the project is said to be viable if the is NPV
positive).

Sensitivity Analysis De ned
Procedures in Sensitivity Analysis
Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Sensitivity Analysis
Break-even Analysis
Sensitivity Analysis Defined
chala Project Identi cation....
Sensitivity analysis focuses analyzing the effects of changes
in key variables on the project's IRR or NPV, the two most
widely used measures of project worth. of use, flexibility and
low cost.
Sensitivity analysis typically involves posing what if?
Questions.
For example, what if demand fell by 10% compared to our
original forecasts? Would the project still be viable?
In project appraisal, sensitivity analysis assesses how responsive the
project's NPV is to changes in the variables used to calculate that
NPV.
The NPV could depend on a number of uncertain independent
variables: (a) Selling price, (b) Sales volume, (c) Cost of
capital, (d) Initial cost, (e) Operating costs, (f) Benefits, etc.
Sensitivity analysis therefore provides an indication of why a
project might fail.

chala Project Identi cation....
Sensitivity Analysis
Break-even Analysis
Sensitivity Analysis
Sensitivity Analysis De ned
Procedures in Sensitivity Analysis
Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Management should
Review critical variables to assess whether or not there is a
strong possibility of events occurring which will lead to a
negative NPV.
Pay particular attentionto controlling those variables to
Which the NPV is particularly sensitive, once the decision
has been taken to accept the investment.
A simple approachto deciding for which variables the NPV
is sensitive to is to calculate thesensitivity of each variable:
Sensitivity = NPV
PV of project variable x 100 % (1)
The lower the percentage, the more sensitive is NPVto
that project variable as the variable would need to change by a
smaller amount to make the project non-viable.

Alemu L. Project Identi cation....
Sensitivity analysis is a technique for investigating the impact
of changes in project variables on the base-case ( most
probable outcome scenario).
Typically, only adverse changes are considered in sensitivity
analysis.
The purpose of sensitivity analysis is:
To help identify the key variables which influence the
project cost and benefit streams
To investigate the consequences of likely adverse changes in
these key variables
To assess whether project decisions are likely to be affected
by such changes
To identify actions that could mitigate possible adverse
effects on the project.
Sensitivity Analysis De ned
Sensitivity Analysis Procedures in Sensitivity Analysis
Break-even Analysis Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
The Purpose of Sensitivity Analysis
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Alemu L. Project Identi cation....
To meet the above purposes, the following steps are
recommended to be followed:
Identify key variables to which the project decision may be
sensitive.
Calculate the effect of likely changes in these variables on
the base-case NPV, and calculate a sensitivity indicator
and/or switching value.
Consider possible combinations of variables that may change
simultaneously in an adverse direction.
Analyze the direction and scale of likely changes for the key
variables identified, involving identification of the sources of
change.
Sensitivity Analysis De ned
Sensitivity Analysis Procedures in Sensitivity Analysis
Break-even Analysis Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Procedures in Sensitivity Analysis
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Sensitivity Analysis De ned
Procedures in Sensitivity Analysis
Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Sensitivity Analysis
Break-even Analysis
Step 1: Identifying the Key Variables
chala Project Identi cation....
The baseline project analysis incorporates many variables:
Quantities and their inter-relationships,
prices or economic values and
The timing of project effects.
It is not necessary to investigate the sensitivity of the project to
variables which are predictable or relatively small in value.
Other variables may be less predictable or larger in value.
As a result of previous experience and analysis of the project
context, a preliminary set of likely key variables include:
Variables which are numerically large(eg. investment cost).
Variables, which may be small, but the value of which is very
important for the design of the project.
Variables occurring early in the project life(eg. investment
costs and initial f i xed operating costs), which will be
relativelyunaffected by discounting.
Variables affected by economic changes(eg. real income).
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Sensitivity Analysis De ned
Procedures in Sensitivity Analysis
Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Sensitivity Analysis
Break-even Analysis
Step 2 and 3: Calculation of e ects of changing variables.
chala Project Identi cation....
b
Xb
s b
NPVb−NPVs
The values of the basic indicators of project viability (ENPV)
should be recalculatedfor different values of key variables.
This is preferably done by calculating sensitivity indicators
and switching values(see below).
Sensitivity Indicators (SI) Switching Value (SV)
Compares percentage change in NPV
with percentage change in a variable
or combination of variables.
SI = (NPVb−NPVs )/ NPVb
The percentage change in a
variable or combination of
variables to reduce the NPV to
zero.
SV =
(Xb −Xs )/ Xb X −X NPV
where:Xb value of variable in the
base case
Xs value of the variable in the
sensitivity test
NPVb value of NPV in the base
case
NPVs value of the variable in
the sensitivity test
x 100

Sensitivity Analysis De ned
Procedures in Sensitivity Analysis
Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Sensitivity Analysis
Break-even Analysis
Step 2 and 3: Calculation of e ects of changing variables.
chala Project Identi cation....
Interpretation
SI: percentage change in NPV.
SV: A change of approximately value of the variable is
necessary before the NPV becomes zero.
Characteristic
SI: Indicates to which variables the project result is or is not
sensitive. Suggests further examination of change in variable.
SV: Measures extent of change for a variable which will leave
the project decision unchanged.
Note: The switching value is, by deffenition, the reciprocal
of the sensitivity indicator.
It can also be calculated by using the sensitivity formula
presented in equation 1.

Sensitivity Analysis De ned
Sensitivity Analysis Procedures in Sensitivity Analysis
Break-even Analysis Applying the Sensitivity Tests
Developing Pessimistic and Optimistic Forecasts
Step 4: Analysis of E ects of Changes in Key Variables
Alemu L. Project Identi cation....
At this point the results of the sensitivity analysis should be
reviewed.
It should be asked:
Which are the variables with high sensitivity indicators;
How likely are the (adverse) changes (as indicated by the
switching value) in the values of the variables that would alter
the project decision?
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