Finance

Finance

Sensitivity analysis involves plugging different numbers into the net present value (NPV ) calculation . The formula is relatively easy to crank through (see the accompanying graphic ) - any good financial calculator today will do it automatically . The challenge still involves coming up with the specific numbers , because one thing sensitivity analysis does not involve is simply pulling numbers out of the air

The first step is to identify the baseline case , which includes the best-guess estimates for the data . The data should be conservative - meaning that it is close to

best case but assumes a few minor bumps in the road along the way

The second step is to define a range for each data item , bounded at the top by the best case and at the bottom by the worst . Conservatism is the operative word here , too . A snowstorm might be factored in as a potential impact on a project 's timetable , but a 100-year-flood or invasion of locusts would be taking things a bit too far

The net present value for several data points within this range is then calculated . This proves to be the most illuminating step because it helps the project manager identify which conditions affect a project 's net present value the most . For example , the higher the interest rate - which is used to convert the expected cash flow from each year of the project to present dollars - the higher the project 's net present value On average , companies assume an interest rate that is between 10 and 20 percent . And , of course , not discounting the cash flows at all will result in a severe overestimate of a project 's ROI

The amount of the estimated cash flows and the timetable for receiving those cash flows have a strong impact on a project 's ROI . Project delays are costly because they push the expected annual savings further into the future , when the value of money is lower . Likewise , unexpected cash infusions into a project push the ROI out . Should quality problems arise only after the product hits the market , sales could plummet far below the initial projections - and this does not even include repair replacement , and warranty costs !In the end , one can hope that most project managers will never have to deal with any worst-case scenarios

Project evaluation is the process that is used to discount cash flows from different projects in order to compare the different projects and determine which project is more profitable

What is discounted cash flow ? Discounted cash flow is simply the flip side of compound interest . A future amount of money is worth less in today 's terms so you 'discount it ' to get the present value

Projects have different durations and cash flows at different point in time . Calculate the net present value for each project by adding the discounted cash flow for each project . The net present value for each project can then be compared to determine which project is more profitable for the business . If a...