Mini Case: 11 – 37
which in turn is likely to be highly correlated with its market risk.
j. 1. What is sensitivity analysis?
j. 2. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital
for the project. Assume each of these variables can vary from its base-case, or
expected, value by 10%, 20%, and 30%. Include a sensitivity diagram, and
discuss the results.
Answer: The sensitivity data are given here in tabular form:
Deviation
from
Base Case
NPV Deviation from
Base Case
r
Units
Sold
Salvage
-30%
$113,270
$84,936
-15%
100,291
52,329
86,473
0%
88,010
88,010
15%
76,378
89,546
30%
65,350
91,083
Range
$47,920
$6,147
We generated these data with a spreadsheet model in the file Ch11 Mini Case Model.xls.
downward sloping, because a higher cost of capital leads to a lower NPV.
website, in whole or in part.
j. 3. What is the primary weakness of sensitivity analysis? What is its primary
usefulness?
Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the
effects of diversification and (2) that it does not incorporate any information about the
indicator. However, sensitivity analysis does identify those variables that potentially
have the greatest impact on profitability, and this helps management focus its attention
on those variables that are probably most important.
k. Assume that Sidney Johnson is confident of her estimates of all the variables that
affect the project’s cash flows except unit sales and sales price. If product
acceptance is poor, unit sales would be only 900 units a year and the unit price
would only be $160; a strong consumer response would produce sales of 1,600
units and a unit price of $240. Sidney believes that there is a 25% chance of poor
acceptance, a 25% chance of excellent acceptance, and a 50% chance of average
acceptance (the base case).
k. 1. What is scenario analysis?
Answer: Scenario analysis examines several possible situations, usually worst case, most likely
k. 2. What is the worst-case NPV? The best-case NPV?
k. 3. Use the worst–, base-, and best-case NPVs and probabilities of occurrence to find
the project’s expected NPV, standard deviation, and coefficient of variation.
website, in whole or in part.
Although simulation analysis is technically refined, its usefulness is limited because
m. 1. Assume that Shrieves’ average project has a coefficient of variation in the range of
0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk?
What type of risk is being measured here?
m. 2. Shrieves typically adds or subtracts 3 percentage points to the overall cost of
capital to adjust for risk. Should the new line be accepted?
m. 3. Are there any subjective risk factors that should be considered before the final
decision is made?
Mini Case: 11 – 42
n. What is a real option? What are some types of real options?
Answer: Real options exist when managers can influence the size and risk of a project’s cash
flows by taking different actions during the project’s life in response to changing
market conditions. Some types of real options are listed below: