Sensitivity and Breakeven

Analysis

Lecture No. 29
Professor C. S. Park
Fundamentals of Engineering Economics
Copyright © 2005
Chapter 10
Handling Project Uncertainty
 Origin of Project Risk
 Methods of Describing
Project Risk
 Probability Concepts
for Investment
Decisions
 Risk-Adjusted Discount
Rate Approach
 In Engineering economics
we predict cash flows
 How do you know for sure
that what you are claiming
for interest rate, costs,
revenues remain true???

 Well for some situations you

can be close enough to
consider your “single point”
analysis to be worthwhile.
 For other you need to
consider what is called RISK
 We use the term risk to describe an
investment project where cash flows are not
known in advanced with certainty.

 What to do: Instead of single point

analysis, an array of outcomes and their
probabilities or odds are to considered.
Origins of Project Risk

 Risk: (in essence) the

potential for loss
 Project Risk: variability
in a project’s NPW
 Risk Analysis: The
assignment of
probabilities to the
various outcomes of an
investment project
Methods of Describing Project Risk
 Sensitivity Analysis: a means of identifying the
project variables which, when varied, have the
greatest effect on project acceptability.

 Break-Even Analysis: a means of identifying the

value of a particular project variable that causes
the project to exactly break even.

 Scenario Analysis: a means of comparing a

“base case” to one or more additional scenarios,
such as best and worst case, to identify the
extreme and most likely project outcomes.
Sensitivity Analysis – Example 10.1

 Transmission-Housing Project by Boston Metal Company

 New investment = $125,000
 Number of units = 2,000 units
 Unit Price = $50 per unit
 Unit variable cost = $15 per unit
 Fixed cost = $10,000/Yr
 Project Life = 5 years
 Salvage value = $40,000
 Income tax rate = 40%
 MARR = 15%
Example 10.1 - After-tax Cash Flow for BMC’s Transmission-
Housings Project – “Base Case”
0 1 2 3 4 5
Revenues:
Unit Price 50 50 50 50 50
Demand (units) 2,000 2,000 2,000 2,000 2,000
Sales revenue $100,000 $100,000 $100,000 $100,000 $100,000
Expenses:
Unit variable cost $15 $15 $15 $15 $15
Variable cost 30,000 30,000 30,000 30,000 30,000
Fixed cost 10,000 10,000 10,000 10,000 10,000
Depreciation 17,863 30,613 21,863 15,613 5,575
Taxable Income $42,137 $29,387 $38,137 $44,387 $54,425
Income taxes (40%) 16,855 11,755 15,255 17,755 21,770
Net Income $25,282 $17,632 $22,882 $26,632 $32,655
(Example 10.1, Continued)
Cash Flow Statement 0 1 2 3 4 5
Operating activities

Net income 25,282 17,632 22,882 26,632 32,655

Depreciation 17,863 30,613 21,863 15,613 5,575

Investment activities

Investment (125,000)

Salvage 40,000

Gains tax (2,611)

Net cash flow ($125,500) $43,145 $48,245 $44,745 $42,245 $75,619

 A B C D E F G
1 Example 10.1 BMC's Transmission-Housings Project
2
13 Income Statement
14 0 1 2 3 4 5
15 Revenues:
16 Unit Price $ 50 $ 50 $ 50 $ 50 $ 50
17 Demand (units) 2000 2000 2000 2000 2000
18 Sales Revenue $ 100,000 $ 100,000 $ 100,000 $ 100,000 $ 100,000
19 Expenses:
20 Unit Variable Cost $ 15 $ 15 $ 15 $ 15 $ 15
21 Variable Cost 30,000 30,000 30,000 30,000 30,000
22 Fixed Cost 10,000 10,000 10,000 10,000 10,000
23
24 Depreciation 17,863 30,613 21,863 15,613 5,581
25 Taxable Income $ 42,137 $ 29,387 $ 38,137 $ 44,387 $ 54,419
26
27 Income Taxes (40%) 16,855 11,755 15,255 17,755 21,768
28 Net Income $ 25,282 $ 17,632 $ 22,882 $ 26,632 $ 32,651
29
30 Cash Flow Statement
31 Operating Activities:
32 Net Income 25,282 17,632 22,882 26,632 32,651
33 Depreciation 17,863 30,613 21,863 15,613 5,581
34 Investment Activities:
35 Investment (125,000)
36 Salvage 40,000
37
38 Gains Tax (2,613)
39 Net Cash Flow $ (125,000) $ 43,145 $ 48,245 $ 44,745 $ 42,245 $ 75,619
40
 Example 10.1 - Sensitivity Analysis for Five
Key Input Variables

Deviation -20% -15% -10% -5% 0% 5% 10% 15% 20%

Unit price $57 $9,999 $20,055 $30,111 $40,169 $50,225 $60,281 $70,337 $80,393

Demand 12,010 19,049 26,088 33,130 40,169 47,208 54,247 61,286 68,325
Variable cost 52,236 49,219 46,202 43,186 40,169 37,152 34,135 31,118 28,101
Fixed cost 44,191 43,185 42,179 41,175 40,169 39,163 38,157 37,151 36,145
Salvage 37,782 38,378 38,974 39,573 40,169 40,765 41,361 41,957 42,553
value

Base
 Sensitivity graph – BMC’s transmission-housings
project (Example 10.1)

$100,000
90,000
80,000
Unit Price
70,000
Demand
60,000
50,000
Salvage value
40,000
Base Fixed cost
30,000
Variable cost
20,000
10,000
0
-10,000
-20% -15% -10% -5% 0% 5% 10% 15% 20%
Example 10.2 - Sensitivity Analysis for Mutually
Exclusive Alternatives
Electrical Diesel
Power LPG Gasoline Fuel

Life expectancy 7 year 7 years 7 years 7 years

Initial cost $30,000 $21,000 $20,000 $25,000
Salvage value $3,000 $2,000 $2,000 $2,200
Maximum shifts per year 260 260 260 260

Fuel consumption/shift 32 kWh 12 gal 11 gal 7 gal

Fuel cost/unit $0.05/kWh $1.00/gal $1.20/gal $1.10/gal

Fuel cost/shift $1.60 $12 $13.20 $7.7
Annual maintenance cost:
Fixed cost $500 $1,000 $1,200 $1,500
Variable cost/shift $5 $6 $7 $9
Capital (Ownership) Cost

 Electrical power:
CR(10%) = ($30,000 - $3,000)(A/P, 10%, 7) + (0.10)$3,000
= $5,845
 LPG:
CR(10%) = ($21,000- $2,000)(A/P, 10%, 7) + (0.10)$2,000
= $4,103
 Gasoline:
CR(10%) = ($20,000-$2,000)(A/P, 10%, 7) + (0.10) $2,000
= $3,897
 Diesel fuel:
CR(10%) = ($25,000 -$2,200)(A/P, 10%, 7) +(0.10) $2,200
= $4,903
Annual O&M Cost

 Electrical power:
$500 + (1.60 + 5)M = $500 + 6.6M
 LPG:
$1,000 + (12 + 6)M = $1,000 + 18M
 Gasoline:
$800 + (13.2 + 7)M = $800 + 20.20M
 Diesel fuel:
$1,500 + (7.7 + 9)M = $1,500 + 16.7M
Annual Equivalent Cost

 Electrical power:
AE(10%) = 6,345 + 6.6M
 LPG:
AE(10%) = 5,103 + 18M
 Gasoline:
AE(10%) = 4,697 + 20.20M
 Diesel fuel:
AE(10%) = 6,403 + 16.7M
 12000

Annual Equivalent Cost ($)

10000

8000
Electrical
LPG
6000
Gasoline
Disel Fuel
4000

2000

0
0
20
40
60
80
100
120
140
160
180
200
220
240
260
Number of Shifts (M)
Break-Even Analysis

 Excel using a Goal Seek function

 Analytical Approach
Excel Using a Goal Seek Function

Goal Seek ? X

Set cell: $F$5 NPW

To value: 0 Breakeven Value

By changing cell: $B$6 Demand

Ok Cancel
 A B C D E F G
1 Example 10.3 Break-Even Analysis
2
3 Input Data (Base): Output Analysis:
4
5 Unit Price ($) $ 50 Output (NPW) $0
6 Demand 1429.39
7 Var. cost ($/unit) $ 15
8 Fixed cost ($) $ 10,000
9 Salvage ($) $ 40,000
10 Tax rate (%) 40%
11 MARR (%) 15%
12
13
14 0 1 2 3 4 5
15 Income Statement
16 Revenues:
17 Unit Price $ 50 $ 50 $ 50 $ 50 $ 50
18 Demand (units) 1429.39 1429.39 1429.39 1429.39 1429.39
Goal Seek 19 Sales Revenue $ 71,470 $ 71,470 $ 71,470 $ 71,470 $ 71,470
20 Expenses:
Function 21 Unit Variable Cost $ 15 $ 15 $ 15 $ 15 $ 15
22 Variable Cost 21,441 21,441 21,441 21,441 21,441
Parameters 23 Fixed Cost 10,000 10,000 10,000 10,000 10,000
24
25 Depreciation 17,863 30,613 21,863 15,613 5,581
26 Taxable Income $ 22,166 $ 9,416 $ 18,166 $ 24,416 $ 34,448
27
28 Income Taxes (40%) 8,866 3,766 7,266 9,766 13,779
29 Net Income $ 13,299 $ 5,649 $ 10,899 $ 14,649 $ 20,669
30
31 Cash Flow Statement
32 Operating Activities:
33 Net Income 13,299 5,649 10,899 14,649 20,669
34 Depreciation 17,863 30,613 21,863 15,613 5,581
35 Investment Activities:
36 Investment (125,000)
37 Salvage 40,000
38
39 Gains Tax (2,613)
40 Net Cash Flow $ (125,000) $ 31,162 $ 36,262 $ 32,762 $ 30,262 $ 63,636
41
 Analytical Approach
Unknown Sales Units (X)
0 1 2 3 4 5
Cash Inflows:
Net salvage 37,389
X(1-0.4)($50) 30X 30X 30X 30X 30X
0.4 (dep) 7,145 12,245 8,745 6,245 2,230
Cash outflows:

Investment -125,000
-X(1-0.4)($15) -9X -9X -9X -9X -9X
-(0.6)($10,000) -6,000 -6,000 -6,000 -6,000 -6,000
Net Cash Flow -125,000 21X + 21X + 21X + 21X + 21X +
1,145 6,245 2,745 245 33,617
 PW of cash inflows
PW(15%)Inflow= (PW of after-tax net revenue)
+ (PW of net salvage value)
+ (PW of tax savings from depreciation

= 30X(P/A, 15%, 5) + $37,389(P/F, 15%, 5)

+ $7,145(P/F, 15%,1) + $12,245(P/F, 15%, 2)
+ $8,745(P/F, 15%, 3) + $6,245(P/F, 15%, 4)
+ $2,230(P/F, 15%,5)

= 30X(P/A, 15%, 5) + $44,490

= 100.5650X + $44,490
 PW of cash outflows:
PW(15%)Outflow = (PW of capital expenditure_
+ (PW) of after-tax expenses
= $125,000 + (9X+$6,000)(P/A, 15%, 5)
= 30.1694X + $145,113
 The NPW:
PW (15%) = 100.5650X + $44,490
- (30.1694X + $145,113)
=70.3956X - $100,623.
 Breakeven volume:

PW (15%) = 70.3956X - $100,623 = 0

Xb =1,430 units.
 PW of PW of
Demand inflow Outflow NPW
X 100.5650X 30.1694X 70.3956X
- $44,490 + $145,113 -$100,623
0 $44,490 $145,113 100,623
500 94,773 160,198 65,425
1000 145,055 175,282 30,227
1429 188,197 188,225 28
1430 188,298 188,255 43
1500 195,338 190,367 4,970
2000 245,620 205,452 40,168
2500 295,903 220,537 75,366
Break-Even Analysis Chart

$350,000
300,000
250,000
Break-even Volume Profit
200,000
PW (15%)

Outflow
150,000

Xb = 1430
Loss
100,000
50,000
0
-50,000
-100,000
0 300 600 900 1200 1500 1800 2100 2400
Annual Sales Units (X)
Scenario Analysis
Variable Worst- Most-Likely- Best-Case
Considered Case Case Scenario
Scenario Scenario
Unit demand 1,600 2,000 2,400
Unit price ($) 48 50 53
Variable cost ($) 17 15 12
Fixed Cost ($) 11,000 10,000 8,000
Salvage value ($) 30,000 40,000 50,000
PW (15%) -$5,856 $40,169 $104,295