Sensitivity Analysis & Types of Interests

8/13/2019 Sensitivity Analysis & Types of Interests

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Financial Planning Is Not JustForecasting


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Typical What-If Questions:

A number of techniques have been developed to help identify the key assumptions in their analysis. These teinvolve asking a number of what-if questions.

What if your market share turns out tohigher or lower than you forecast?

What if interest rates rise during th


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SoUncertainty means that more things CANHAPPWILLHAPPEN.


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SENSITIVITYANALYSTYPESOFINTEREST

PRESENTEDBY2010-CH-01 2010-CH-19 2010-CH-7

2010-CH-123


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Whenever managers are cash-flow forecast, they

determine what else mighand the implications opossible events. This iSENSITIVITYANALYSIS.


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DEPRECIATION

What is truedepreciation? It is the amount that the firm simply to offset any deterioration in its assets.

The purpose of depreciation is to allocate the original cosover its life, and the rules governing the depreciation of asnot reflect actual loss of market value.

As a result, the book value of fixed assets often is muchthe market value, but often it is less.


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CASHFLOWS

THEMOVEMENTOFMONEYINTOANDOUTOFA

But since cash flows rarely proceed as anticipated

constantly need to modify their operations.If cash flows are better than anticipated, the project may b

if they are worse, it may be scaled back or abandoned alto


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How to perform SENSITIVITYANALYSIS

First of all DEFINE OBJECTIVE

Secondly Look for the variables affecting yourobjective parameter

Look for the desired variable to apply analysis

Take some assumptions to carry out analysis

Make the analysis


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PROBLEMSTATEMENT

A project currently generates sales of $10 million, variabcosts equal to 50 percent of sales, and fixed costs of $2million. The firms tax rate is 35 percent. What are the efof the following changes on after-tax profits and cash flo

a) SALESINCREASEFROM$10 MILLIONTO$11 MILLION.

b) VARIABLECOSTSINCREASETO60 PERCENTOFSALES.

FUNDAMENTALSOFCORPO

RICHARDA. BREALEYCAHPATER


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Analysis before Analysis

Available variables: Sales Variable Costs Fixed Costs Tax Rate After-tax Profits

Objective Parameter: After-tax Profits

To Vary:1. Overall Sales2. Variable Costs

Conclude their results on OBJECTIVE FUNCTION


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Assumptions

To keep the example simple we have assumed

I. NOINFLATION

II. We Have Also Assumed That The Entire Investment CaDEPRECIATEDSTRAIGHT-LINEFORTAXPURPOSES

III. We Have Neglected The WORKINGCAPITALREQUIREM


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Initial After Tex Profit?

Given Data:

Current Sale: $10 millionVariable Cost = 50 percent of SalesFixed Costs = $2 million

Tax Rate= 35 percentAfter-tax Profit = (Net Profit)*(Tax free fraction)

{ [Sales * (1 - variable cost)] - fixed cost } * tax rate) = AT Profit


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Net Profit & Tax freefraction

Tax free fraction = 1(tax percentage on profit)

TFF= 75% or 0.75

Net Profit= { [Sales * (1 - variable cost)] - fixed cost }Sales= $10 millionVariable Cost Fr= 0.50Fixed Cost= $2 million

Net Profit= $3 million


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AT-Profit at new sales value

Sales=$11 million

Rest of the parameters are kept constant i.eVariable Cost = 50 percent of Sales

Fixed Costs = $2 millionTax Rate= 35 percent

Tax free fraction = 1(tax percentage on p

TFF= 75% or 0.75


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Net Profit

Net Profit= { [Sales * (1 - variable cost)] - fixed cost }

Sales= $11 millionVariable Cost Fr. = 0.50Fixed Cost= $2 million

Net Profit= $3.5 million


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AT-Profit

After-tax Profit = (Net Profit)*(Tax free fractio

After-tax Profit = $3.5 million*0.75

After-tax Profit = $2.625 million


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Part-b

Keep the sales at $10 million and the otherparameters

But vary the Variable cost percentage

Given Data:Product Sale: $10 millionVariable Cost = 50 percent of SalesFixed Costs = $2 millionTax Rate= 35 percent


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AT-Profit at initial Percentage

This would be as calculated for the part-a as the given data isame

SoAt 50% Variable Cost



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AT-Profit at new Percentage

Variable percentage: 60 PERCENT

RESTSOFTHEDATAISTHESAME:ProductSale: $10 millionFixed Costs = $2 millionTax Rate= 35 percent

Tax free fraction = 1(tax percentage on profit)

TFF= 75% or 0.75


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Net Profit

Net Profit= { [Sales * (1 - variable cost)] - fixed cost }

Sales= $10millionVariable Cost Fr= 0.65Fixed Cost= $2 million

Net Profit= $1.5 million


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AT-Profit

After-tax Profit = (Net Profit)*(Tax free fraction)

After-tax Profit = $1.5 million*0.75



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Conclusion

Part-a

An Increase in Sales Increase in AT-Pro

Part-b

An Increase in Variable Cost %age decrin AT-Profit


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Limits to Sensitivity Analysis

I. Of course, there is no law stating which vashould consider in your sensitivity analysis. Foyou may wish to look separately at labor costs an

of the goods sold. Or, if you are concerned aboutchange in the corporate tax rate, you may wish toeffect of such a change on the projectsNPV.


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II. One drawback to sensitivity analysis is that it giveambiguous results. For example, what exactly does pessimistic mean? One department may be interpreting different way from another. Ten years from now, afterprojects, hindsight may show that one departments pe

was exceeded twice as often as the others; but hindsigyou now while youremaking the investment decision.



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III. Another problem with sensitivity analysis is that the uvariables are likely to be interrelated. For exampleexceed expectations, demand will likely be stronger anticipated and your profit margins will be wider. Or, are higher than your forecast, both variable costs a

costs are likely to be at the upper end of your range. of these connections, you cannot push one-at-a-time sanalysis too far.



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Interest which is calculated not only on the initial

principal but also the accumulated interest of prio

periods.

Compound interest can be thought of as inte

on interest,

OR

COMPOUNDINTEREST


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The formula for calculating the compound interest is:

Where:F = future value

P = initial depositr = interest rate (expressed as a fraction: e.g.. 0.06 for 6%)n = # of times per year interest is compoundedt = number of years invested

F = P(1+ r/n)nt


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Savings accounts

Credit cards

Loans

Compounded for daily, quarterly (4 times a year) , semi-annually

year), or annually (once a year)

Applies On..


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FACTORSAFFECTINGCOMPOUNDIN

Interest Rate

Duration

Initial Amount


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Interest Rate More is the Interest rate (r) more is the

future amount

Initial Amount

More is the principal amount (P) for deposit more is

the future amount

Compounding Frequency

More is the compounding frequency (n) for depo

is the future amount


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Compounding DifferentInterest Rates


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Case Study(i)

If you start a bank account with amount $10,000

bank compounds the interest quarterly at an inter

8%, how much money do you have at the 5th ye

(assume that you do not add or withdraw any m

the account)GIVEN DATA

P= $10,000 R= 0.08 N= 4 T= 5 years


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F = 10000 (1+(.08/4))^(4*5)

F = 10000 (1+0.02)^(20)

F = 10000 (1.02)^(20)

F = 10000 (1.4859)F = $ 14859.47

So the future amount will be 14859.47 dollars a


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How much money would you need to deposit today at

annual interest compounded monthly to have $12,000

account after 6 years?

GIVEN DATA

F= $12,000

R= 0.09

T= 6 years

Case Study(ii)


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12000 = P (1+(.09/12))^(12*6)

12000 = P (1+0.0075)^(72)

12000 = P (1.0075)^(72)

12000 = P (1.7125)P= $ 7007.3

So the principle amount should be 7007.3 d


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If you deposit $5000 into an account paying 6% a

interest compounded monthly, how long until tha

amount becomes double in the account?

GIVEN DATA

P = 5000 F = 10000 N = 12

R = 0.06

Case Study(iii)


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t 11.6 months

10000 = 5000 (1+(.06/12))^(12t)2 = (1+0.005)^(12t)

2 = (1.005)^(12t)

Taking logarithm on both sidesLog(2)= 12t * log(1.005)

0.301 = (12*0.00216) * t

So it will take about 11.6 months to make the amou


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c. Compound interest formula contains exponent while simpleinterest has linear multiplication.

a. Compound interest can be paid month or day basisalso.But simple is paid after one year.

Simple vs. Compound

b. Compound interest makes a deposit or loan grow faster rate than simple interest, which is inte

calculated only on the principal amount.


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Sensitivity Analysis & Types of Interests

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