(216)---SIMULATION ANALYSIS

Simulation Analysis

The sensitivity analysis and scenario analyses are quite useful to understand the uncertainty of the investment projects. But both approaches suffer from certain weakness. They do not consider the interactions between variables and also, they do not reflect on the profitability of the change in variables.

Simulation analysis considers the interactions among variables and profitability of the change in variables. It does not give the projects net present value as a single number rather it computes the profitability distribution of value. The simulation analysis is an extension of scenario analysis. In simulation analysis a computer generates a very large number of scenarios according to the profitability distributions of the variables. The analysis involves the following steps:

• First, you should identify variables that influence cash inflows and outflows. For example, when a firm introduces a new product in the market these variables are initial investment, market size, market growth, market share, price, variable costs, fixed costs, product life cycle, and terminal variable.
• Second, specify the formulae that relative variables. For example, revenue depends on by sales volume and price; sales volume is given by market size, market share, and market growth. Similarly, operating expenses depend on production, sales and variable and fixed costs.
• Third, indicate the profitability distribution for each variable. Some variables will have more uncertainty than others, For example, it is quite difficult to predict price or market growth with confidence.
• Fourth, develop a computer programme that randomly selects one variable from the profitability distinction of each variable and uses these values to calculate the projects’ net present value. The computer generates a large number of such scenarios, calculates net present values and stores them. The stored values are printed as a profitability distribution of the projects’ values along with the expected value and its standard deviation. The risk-free rate should be used as the discount rate to compute the projects’ value. Since simulation is performed to account for the risk of the projects’ cash flows, the discount rate should reflect only the time value of money.

That analysis is a very useful technique for risk analysis. Unfortunately, its practical use is limited because of a number of shortcomings. First, the model becomes quite complex to use because the variable depends are interrelated with each other, and each variable depends on its values in the previous periods as well. Identifying all possible relationships and estimating probability distribution is a difficult task; its time consuming as well as expensive. Second, the model helps to generating a profitability distribution of the projects’ net present values. But it does not indicate whether or not the project should be accepted. Third, considers the risk of any project in isolation of other projects.

(215)---SENSITIVITY ANALYSIS

Sensitivity Analysis

In the evaluation of an investment project, we work with the forecasts of cash flows. Fore casted cash flows depend on the expected revenue and costs. Further, expected revenue is a function of sales volume and unit selling price. Similarly, sales volume will depend on the market size and firms’ market share. Costs include variable costs, which depend on sales volume, and unit variable cost and fixed costs. The net present value or the internal rate of return of a project is determined by analyzing the after tax cash flows arrived at by combining forecasts of various variables. It is different to arrive at an accurate and unbiased forecast of each variable. We can’t’ be certain about the outcomes of any of these variables. The reliability of the net present value or internal rate of return of the project will depend on the reliability of the forecasts of each variable underlying the estimates of net cash flows. To determine the reliability of the projects’ net present value or internal rate of return, we can work out how much difference it makes if any of these forecasts goes wrong. We can change each of the forecasts, one at a time, to at least three values, expected, and optimistic. The net present value of the project is recalculated under these different assumptions. This method of recalculating net present value or internal rate of return by changing each forecast is called sensitivity analysis.

Sensitivity analysis is a way of analyzing change in the projects’ values for a given change in one of the variables. It indicates how sensitive a projects’ value is to changes in particular variables. The more sensitivity of the value, the more critical is the variable. The following three steps are involved in the use of sensitivity analysis:

• Identification of all those variables, which have an influence on the projects value
• Definition of the underlying (mathematical) relationship between the variables
• Analysis of the impact of the change in each of the variables on the projects value

The decision maker, while performing sensitivity analysis computes the projects net present value or internal rate of return for each forecast under three assumptions.

1. Pessimistic,
2. Expected,
3. Optimistic.

It all allows him to ask “what if”. For example, what if volume increase or decreases? What if variable cost or fixed cost increases or decreases? What if the selling price increase or decreases? What if the project is delayed or outlay escalates or the projects life is more or less than anticipated? A whole range of questions can be answered with the help of sensitivity analysis. It examines the sensitivity of the variables underlying the computation of net present value or internal rate of return, rater than attempting to quantify risk. It can be applied to any variable, which is an input for the after tax cash flows.