Sensitivity, Breakeven and

Indifference Analyses
Additional Topics: Internal Rate of
Return, Inflation and Interest Rate

Internal Rate of Return

IRR: Internal Rate of Return
Defined as the discount rate that sets NPV to 0
NPV = PV of future CFs CF0
NPV = -CF0 + CF1/(1+r)1 + CF2/(1+r)2 + .. +CFt/(1+r)t
NPV = 0 = -CF0 + CF1/(1+IRR)1 + CF2/(1+IRR)2 + .. +CFt/
(1+IRR)t

Can only be solved using an iterative method

Excel function IRR()

NPV Profile
A graph showing the relationship between NPV and discount
rate

IRR Example
Multiple Cash Flows
Including special forms such as annuities

E.g.
Bond Cash Flows
Price Today
Coupon Payments
Face (Par) Value at Maturity
Micros oft Office
Excel Works heet

Sensitivity Analysis
Sensitivity Analysis
Change one input variable at a time
Similar to taking partial derivative
With Excel data table, we can analyze
impact on multiple output (decision)
variables simultaneously
Micros oft Office
Excel Works heet

Sensitivity Analysis using Data Table

Data Table
Organization
1 input
Row or Column
Basic sensitivity analysis
Allow multiple output variables

2 inputs
Change 2 input variables simultaneously
Allow only one output variable

Modifying Data Table

Must delete entire table range

Key
Model must be flexibly coded
A useful tool for checking model integrity in addition to providing
sensitivity analysis

Breakeven versus Indifference

Breakeven
A minimum hurdle

Indifference
Choosing among alternatives

Breakeven and indifference are similar

There is always an alternative: DO NOTHING

Modeling Tips
Create a Net gain variable for indifference analysis
E.g. Net gain of project A = NPVA NPVB
Indifference -> NPVA = NPVB
Breakeven -> Net gain of project A = 0

Sales Quantity
Accounting Breakeven analysis often focus on sales

quantity

Pro forma statements are typically sales-driven

(Accounting) Breakeven Sales Quantity

QBE = FC / (p vc)
FC is fixed costs, p is unit price, vc is unit variable costs

Cash Flow Breakeven

Sales level resulting in $0 operating cash flows
QBECF = (FC - Depreciation expense) / (p vc)

NPV Breakeven
Sales level resulting in $0 NPV
No closed form solution

Goal Seek
Goal Seek
Useful for simple models: e.g. linear model
Can only search for solutions to a specific value
Cannot do general search, such as finding the maximum
Set Cell
This is usually the decision variable

E.g. Accounting breakeven -> Net profit

NPV breakeven -> NPV
Retirement Planning -> Ending Balance
Should be a cell containing a formula

To value
E.g. Breakeven -> 0
Can modify to include target profit or bequest amount

By Changing
Should be an input variable to the model
Can only change one cell
E.g. Sales quantity
Annual Savings

Solver
Add-ins
More powerful than Goal Seek
Can solve for maximum or minimum in addition to a
specific value
Can handle nonlinear functions
Note: A nonlinear function need not be complicated. E.g.
MAX(0,A1) is a nonlinear function

Set target cell

Similar to Set Cell in goal seek

Solver (continued)
Equal to
Max, Min, or value
For breakeven analysis, equal to 0

Changing cells
Can change multiple cells simultaneously
If changing more than one cell, you usually need to impose
constraints. Otherwise, there may be many possible solutions.
E.g. x + y = 3. The number of possible solutions for x and y are
infinite. If x and y are restricted to positive integers, the number of
possible solutions reduce significantly.
E.g. Your goal is to find the breakeven NPV. If changing cells
include both unit price and unit variable costs, there will not be a
unique solution.

Solver (continued)
Subject to the Constraints
Depends on the nature of the problem
We will discuss constraints more later in
portfolio optimization

Inflation and Interest Rate

Fisher Relation
Inflation Premium: real versus nominal rates
Fisher Relation:
(1 + Nominal) = (1 + real) x (1 + inflation rate)

Can be approximated by
Nominal rate real rate + expected inflation

Cash Flow and Discount Rate

Use real discount rate for real cash flows, i.e.

cash flows that have not been adjusted for

inflation
Use nominal discount rate for nominal cash flows
Accounting data usually contains mixed cash
flows
E.g. revenue and cash expenses are usually current,
i.e. these are nominal CFs
Depreciation is based on historic price and has not
been adjusted for the effects of inflation

Consequences of using the

wrong discount rate
Use real discount rate for nominal cash flows
Overstates PV when inflation rate > 0
Invest in poor projects/investments

Use nominal discount rate for cash flows that

have not been adjusted for inflation

Understates PV when inflation rate > 0
Reject valuable projects/investments

Inflation rate is usually positive