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 projects 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 BMCs

Transmission-Housings Project Base Case
0

Revenues:
Unit Price
Demand (units)
Sales revenue

50

50

50

50

50

2,000

2,000

2,000

2,000

2,000

$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

16,855

11,755

15,255

17,755

21,770

$25,282

$17,632

$22,882

$26,632

$32,655

Income taxes (40%)

Net Income

(Example 10.1, Continued)

Cash Flow Statement

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

Example 10.1 - Sensitivity

Analysis for Five Key Input
Variables
Deviation

-15%

-10%

-5%

0%

5%

10%

15%

20%

$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
value

37,782

38,378

38,974

39,573

40,169

40,765

41,361

41,957

42,553

Unit price

-20%

Base

Sensitivity graph BMCs transmissionhousings project (Example 10.1)

$100,000
90,000

Unit Price

80,000
70,000

Demand

60,000
50,000

Salvage value

40,000

Fixed cost

Base

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

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

Break-Even Analysis

Excel using a Goal Seek function

Analytical Approach

Excel Using a Goal Seek

Function
?

Goal Seek
Set cell:

X
NPW

$F$5
0

To value:
By changing cell:
Ok

Breakeven Value

$B$6
Cancel

Demand

Goal Seek
Function
Parameters

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39

Example 10.3 Break-Even Analysis

Input Data (Base):
Unit Price ($)
Demand
Var. cost ($/unit)
Fixed cost ($)
Salvage ($)
Tax rate (%)
MARR (%)

Output Analysis:
$
$
$
$

50
1429.39
15
10,000
40,000
40%
15%

Output (NPW)

0
Income Statement
Revenues:
Unit Price
Demand (units)
Sales Revenue
Expenses:
Unit Variable Cost
Variable Cost
Fixed Cost
Depreciation

$0

50 $
50 $
50 $
50 $
50
1429.39
1429.39
1429.39
1429.39
1429.39
$ 71,470 $ 71,470 $ 71,470 $ 71,470 $ 71,470
$

15
21,441
10,000
17,863

15
21,441
10,000
30,613

15
21,441
10,000
21,863

15
21,441
10,000
15,613

15
21,441
10,000
5,581

Taxable Income
Income Taxes (40%)

22,166
8,866

9,416
3,766

18,166
7,266

$ 24,416
9,766

34,448
13,779

Net Income

13,299

5,649

10,899

$ 14,649

20,669

10,899
21,863

14,649
15,613

Cash Flow Statement

Operating Activities:
Net Income
Depreciation
Investment Activities:
Investment
Salvage
Gains Tax

40 Net Cash Flow

41

13,299
17,863

5,649
30,613

20,669
5,581

(125,000)
40,000
(2,613)
$ (125,000) $

31,162

$ 36,262

32,762

$ 30,262

63,636

Analytical Approach
Unknown Sales Units (X)
0

Cash Inflows:
Net salvage

37,389
30X

30X

30X

30X

30X

7,145

12,245

8,745

6,245

2,230

-X(1-0.4)($15)

-9X

-9X

-9X

-9X

-9X

-(0.6)($10,000)

-6,000

-6,000

-6,000

-6,000

-6,000

21X +
1,145

21X +
6,245

21X +
2,745

21X +
245

21X +
33,617

X(1-0.4)($50)
0.4 (dep)
Cash outflows:
Investment

Net Cash Flow

-125,000

-125,000

 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%)
Xb

= 70.3956X - $100,623 = 0
=1,430 units.

PW of
inflow

PW of
Outflow

NPW

100.5650X
- $44,490

30.1694X
+ $145,113

70.3956X
-$100,623

$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

Demand

Break-Even Analysis Chart

$350,000
300,000

w
Inflo

250,000

Break-even Volume

Profit

Outflow

150,000

X b= 1430

PW (15%)

200,000

Loss

100,000
50,000
0
-50,000
-100,000
0

300

600

900

1200

1500

Annual Sales Units (X)

1800

2100

2400

Scenario Analysis
Variable
Considered

WorstCase
Scenario

Most-LikelyCase
Scenario

Best-Case
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