ADMS 3530 Winter 2012 – Professor Lois King
Lecture 8 – Capital Budgeting II – Feb 28
8.1 Sensitivity & Scenario Analysis
− Sensitivity Analysis
o Changing a single variable within a range from most likely to optimistic to
pessimistic and then evaluating the resulting NPVs.
o Assumes that the individual variables are independent of each other.
− Scenario Analysis
o Several variables or a combination of variables are changed under a different set
of assumptions (more realistic).
− Simulation Analysis
o An extension of scenario analysis.
o A computer generates hundreds or thousands of possible outcomes of combination
o The different estimates for the variables are calculated using probability
distributions and the project NPV is then calculated.
8.2 BreakEven Analysis
− Accounting breakeven level of revenues =
o Fixed costs plus depreciation – additional profit from each additional dollar of
o Fixed costs plus depreciation – ( 1 – variable costs per dollar of sales)
Accounting breakeven tells you the level of sales at which profits = zero
(or where total costs = total revenues).
− NPV (or Economic) BreakEven
o This can be defined as the level of sales at which NPV switches from positive to
o Or where PV of cash flows = investment.
8.3 Operating Leverage
− Fixed costs = costs incurred regardless of the level of output.
− Variable costs = costs that vary directly with sales.
− Accounting breakeven ▯depends on the level of fixed costs.
− Operating Leverage
o The degree to which a project’s costs are fixed If a project has mostly fixed costs, it is said to have high operating
High operating leverage implies that profits are more sensitive to changes
8.4 The Valu