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Unformatted text preview: 10 Sensitivity and Uncertainty Analysis In Chapter 9, it was assumed that all values of costs, expenses, revenues, economic lives, and acceptable rates of return were known with certainty. This was done to focus on the methodology of estimating profitability and ultimately decision making. This high degree of confidence is referred to as analysis under assumed certainty ; therefore, decisions based on this analysis are decisions under certainty . Whenever a project is proposed, market surveys, market price projections, market share, and ultimately revenues are estimated. Capital costs and operating expenses are estimated as in Chapters 4 and 5, respectively. From these data, profitability of a project is calculated. All these estimates are based on what is believed to be the best available data. Errors inherent in all estimates, and the effect of these errors on profitability, will be considered in this chapter. Sensitivity analysis is used to determine the effect of technical and economic parameters on the profitability of a project. The potential error of each parametric variable is examined, as well as its effect on the project. Questions such as “What if the capital investment is 15% greater than the estimated value?” or “What if the market is 20% less than the best estimate?” can be resolved by determining the effect of percentage changes in these variables on profitability and will be addressed subsequently in this chapter. In uncertainty analysis, probabilistic distributions are assigned to each variable to be considered and a methodology is used to determine the resulting profitability measure expressed as either the “probability of achieving more than or at least a specified return on investment or a net present worth.” Sensitivity analysis is easy to use but the results have definite limitations. Uncertainty analysis requires much more sophistication on the part of the person performing the analysis. The executives who will use the results need to be educated in the method used and the meaning of the results; otherwise wrong decisions could be made concerning the fate of a future venture. 10.1 SENSITIVITY ANALYSIS Sensitivity analysis is concerned with the extent of change in a cost analysis resulting from variations in one or more elements of a cost study. It shows the inﬂuence of possible changes of significant variables upon profitability. From this analysis, those variables that have a critical effect are identified. Especially important are those variables that might alter a decision when only small changes occur. The ordinary practice is to make a number of computations of profitability, varying each significant cost element over the most likely range of values. This process can be tedious unless a computer is used. A visual aid, e.g., a plot or graph, depicts the most sensitive variables in a cost study. Managers prefer a graphic illustration rather than tables of numerical values because significant results can be overlooked in tables.results can be overlooked in tables....
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This note was uploaded on 10/28/2008 for the course N n taught by Professor N during the Spring '08 term at Punjab Engineering College.
- Spring '08