Forecasting Free Cash Flows:

Sensitivity, Scenario and Break-even Analysis

Introduction

The calculation of the NPV (net present value) requires many forecasts including

• sales quantities
• prices
• variable costs, and
• fixed costs.

The uncertainty of the forecasts leads to uncertainty about the NPV. In this lecture, we
will learn some techniques that help a manager make better-informed decisions using
NPV analysis. These techniques are sensitivity analysis, scenario analysis, and break-
even analysis.

Sensitivity and Scenario Analysis

 Sensitivity analysis looks at how responsive (sensitive) the NPV of a project is to

changes in the underlying assumptions.

 Sensitivity analysis is performed by modifying the initial assumptions and then

calculating and examining the resultant Net Present Values.

 Sensitivity analysis is typically performed by changing one assumption concerning

one forecast (such as sales or prices) at a time. Scenario analysis is a form of
sensitivity analysis and consists of an analysis of a capital project’s acceptability
under three sets of assumptions: pessimistic, most likely, and optimistic. Computer
programs allow for complex sensitivity analysis to be performed.

 Sensitivity analysis identifies the “value drivers” of a project so it can be used to

determine where resources should be spent to reduce uncertainty.

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Example: BIKE Corporation is considering the introduction of a motor scooter. The
staff has put together the following cash-flow forecasts (figures in millions of dollars).
The initial cost of this project is $150 million. Assume a discount rate of 10%. Find the
NPV.

Assumptions used to obtain Cash Flows:

 Size of the Scooter market: 1 million units

 BIKE’s Market share: 10%

 Unit Sales Price: $3,750

 Unit Variable Cost: $3,000

 Annual Fixed Costs: $30,000,000

Calculation of Revenue:

Revenue = (Size of Scooter market)(BIKE’s Market share)(Unit Sales Price)

= (1,000,000)(0.10)($3,750)

= $375,000,000

Year 0 Years 1-10

Initial Investment $150
1. Revenue $375
2. Variable cost 300
3. Fixed cost 30
4. Depreciation (10-year straight line) 15
5. Pretax profit (1 – 2 – 3 - 4) 30
6. Tax (50% tax rate) 15
7. Net Profit (5 - 6) 15
8. Operating cash flow (4 + 7) 30
Net cash flow -$150 +$30

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Calculation of NPV if the expected occurs

  1 
 
1 −(1 +.10 )10 


  
NPV = −$150 +$30   =$34 .34
.10
 

 


Question 1: Your forecasters are extremely concerned about their assumption regarding
market share. They feel it is extremely likely that BIKE will only capture 4% of the
market. How will this impact the decision? Recalculate the NPV for the project.

Question 2: Go back to the original assumptions. Now assume that forecasters think that
a possibility exists that the unit variable costs might only be $2,750. How will this
impact the decision? Recalculate the NPV for the project.

The above calculations are an example of sensitivity analysis. The table below shows the
results of sensitivity analysis on all the estimates used to arrive at cash flows.

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 Sensitivity Analysis

Consider the following table of alternative assumptions:

NET PRESENT VALUE

RANGE Millions of Dollars
Variable Pessimistic Expected Optimistic Pessimistic Expected Optimistic
Market
size .9 million 1 million 1.1 million +11 +34 +57
Market
share 4% 10% 16% +34 +173
Unit Price $3500 $3750 $3800 -42 +34 +50
Unit
Variable
Cost $3600 $3000 $2750 -150 +34
Fixed Cost $40 million $30 million $20 million +4 +34 +65

Note: The NPVs in the table above are obtained by changing

one assumption at a time.

Limits to Sensitivity Analysis

 The range of NPV depends on the choice of optimistic and pessimistic assumptions.

 It can be difficult to identify interrelationships among the assumptions.

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Break-Even Analysis

 Break-even analysis determines the sales needed to break even.

 Break-even sales levels can be calculated in terms of both accounting profit and
present value.

 Accounting profit break-even uses annual expenses as calculated using

accounting rules.

 Present value break-even uses the equivalent annual cost of the initial
investment. The equivalent annual cost is the amount we would have to pay for
the initial investment if we divided it up evenly over its lifetime taking into
account the time value of money.

Example (continued using previous data):

Accounting Profit Break-Even

After-tax profit per unit:

(Unit Price – Variable Cost) (1 – Tc) =

($3750 - $3000) (1 - .5) =
$375

This value is known as the contribution margin since it represents the additional
amount that each motor scooter contributes to after-tax profit.

After-tax annual accounting costs:

(Fixed costs + Depreciation) (1 – Tc) =

(30 + 15) (1 - .5) =
$22.5 Million

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Accounting Break-even is the number of scooters that makes after-tax profits equal to
after-tax annual accounting costs.

Practice 1: You are considering investing in a fledgling company that cultivates abalone
for sale to local restaurants. The proprietor says he’ll return all profits to you after
covering operating costs and his salary.

a) How many abalone must be harvested and sold in the first year of operations for you to
get any payback? (Assume no depreciation.)

Price per adult abalone = $2.00

Variable costs = $0.72
Fixed costs = $300,000
Salaries = $40,000
Tax rate = 35%

b) How much profit will be returned to you if he sells 300,000 abalone?

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Present Value Break-Even

After-tax profit per unit:

(Unit Price – Variable Cost) (1 – Tc) =

($3750 - $3000) (1 - .5) =
$375

After-tax annual economic costs:

EAC + Fixed costs (1 – Tc) – Depreciation (Tc)

Note: The initial investment was $150 million. Use the annuity equation to obtain
the Equivalent Annual Cost (EAC).

Present Value Break-Even is the number of scooters that makes after-tax profits equal to
after-tax annual economic costs.

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Practice 2: Given the information from Practice 1, what is the present value break-even
point if the discount rate is 15 percent, initial investment is $140,000, and the life of the
project is seven years? Assume a straight-line depreciation method with a zero salvage
value.