Module 8: Breakeven and Sensitivity

Analysis (Chap 11)

 Chapter Objectives

At the end of this chapter, you will be able to:

• Investigate variability of project outcomes

• Evaluate sensitivity parameter

• Determine the breakeven conditions

2
 Case Study 1 – Boeing 737 MAX

In responding to Airbus A320neo, Boeing

invested in upgrading the best selling 1960s
airframe and countered with their own
B737MAX. To increase efficiency and
distance they invested on developing a bigger
engine and make modification to the wing
structure as well as upgrade the flight control
systems.

❑ At issue:
o What would be Boeing’s financial risk in
this expansion project?
o How should Boeing factor the future
fluctuation and uncertainty of aircraft
demand into the analysis?
o How sensitive would these prediction be in
the likelihood of unseen risks such as the
recent crashes currently being
investigated.
Case Study 1 – Boeing 737 MAX
 Certainty Conditions

To this point we have assumed a high degree of confidence in estimated values.

 The degree of confidence is sometimes called assumed certainty, and decisions
made on the basis of this kind of analysis are called decisions under certainty.
 In virtually all situations, ultimate economic results are unknown.
 Breakeven and sensitivity analysis are used to help understand how our
decision might be affected if our original estimates are incorrect.
 Project Risks

 Sensitivity analysis: A procedure of identifying the project variables

which, when varied, have the greatest effect on project acceptability
 Breakeven analysis: A procedure of identifying the value of a
particular project variable that causes the project to exactly break
even
 Scenario analysis: A procedure of comparing a “base case” to one or
more additional scenarios, such as best and worst cases, to identify
the extreme and most likely project outcomes
 Breakeven Conditions
The breakeven point is the value of a key factor at which we are indifferent
between two alternatives (one may be “do nothing”).

The breakeven point is the value of y where

 Breakeven Analysis

Breakeven analysis is a tool used to determine when a business will

be able to cover all its expenses and begin to make a profit from a
project.
Common factors to consider for breakeven analysis.
 annual revenue and expenses
 rate of return
 market (or salvage) value
 equipment life
 capacity utilization
 Example 1 – Grabcar

Should Jim sell his grabcar?

Jim's 1998 Honda is quite functional, but it only averages 20 miles per gallon (mpg).
He has found a somewhat newer vehicle (roughly the same functionality) that
averages 26 mpg. He can sell his current car for $2800 and purchase the newer
vehicle for $4,000. Assume a cost of gasoline $4.00 per gallon. How many miles per
year must Jim drive if he wants to recover his investment in three years? Assume an
interest rate of 6%, zero salvage value for either vehicle after three years, and
identical maintenance cost.
 Example 1 – Grabcar

Current car
𝑥
𝑃𝑊1 = 2,800 + 4.00 𝑃Τ𝐴 , 6%, 3 = 2,800 + 0.5346𝑥
20

New vehicle
𝑥
𝑃𝑊2 = 4,000 + 4.00 𝑃Τ𝐴 , 6%, 3 = 4,000 + 0.4112𝑥
26

Equating these, and solving for x, we find

𝑥 = 9,724 𝑚𝑖𝑙𝑒𝑠/𝑦𝑒𝑎𝑟

Economical if he drives more than this

 Exercise 1 – Car Rebate

The “one time good deal” Cash-For-Clunkers program offered by the federal
government proved a temporary boon for car dealers. In addition to this
program, dealers were eager to add their own incentives. Bill Mitselfik was
considering two different deals he could make for his new car. He can finance
the purchase price, $25,000, entirely through the dealer at a 1.9% APR
(compounded monthly) for 5 years, with payments monthly. Alternatively, the
dealer will give Bill a cash rebate and provide financing at 9% APR
(compounded monthly) for 5 years, with monthly payments. What is the value
of the rebate for which Bill would be indifferent between the two financing
options?
 Exercise 1 – Car Rebate

The “one time good deal” Cash-For-Clunkers program offered by the federal
government proved a temporary boon for car dealers. In addition to this
program, dealers were eager to add their own incentives. Bill Mitselfik was
considering two different deals he could make for his new car. He can finance
the purchase price, $25,000, entirely through the dealer at a 1.9% APR
(compounded monthly) for 5 years, with payments monthly. Alternatively, the
dealer will give Bill a cash rebate and provide financing at 9% APR
(compounded monthly) for 5 years, with monthly payments. What is the value
of the rebate for which Bill would be indifferent between the two financing
options?
𝐴 𝑃Τ𝐴 , 1.9%, 60 = 25,000
35.618A = 25,000
A = $701.89

25,000 − 𝑋 = 701.89 𝑃Τ𝐴 , 9%, 60 = 701.89 11.408 = 8,007.16

𝑋 = $16,992.84
 Sensitivity Analysis

We use sensitivity analysis to see what happens to project profitability when

the estimated value of study factors are changed.
 What if expenses are 10% higher than expected—is the project profitable?
 What if sales revenue is 15% lower than expected?
 What change in either expenses or revenues will cause the project to be
unprofitable (decision reversal)?
 Example 2 – Grabcar (revisited)

Reconsidering Jim's Grabcar.

Considering that Jim drives about 10,000 miles per year, our previous
analysis would indicate that he should purchase the vehicle that gets better
mileage. However, what if gas prices drop by 10% (price now $3.60)?
Should Jim still sell his gas-guzzling car?

So, if gas prices drop by 10%, Jim should keep his car.
 Exercise 2 – Car Rebate

Acme Delivery is considering a proposal for new package tracking

technology. The system has an estimated initial cost of $1.9 million and
will require upgrades and maintenance of $140,000 each year. Acme
estimates that improved tracking will save approximately $680,000 per
year, after system operating expenses. Acme has a MARR of 15% per
year, and the study period for this technology is 6 years, after which time
Acme expects the entire system will need to be replaced. The PW of this
proposal is

PW(15%) = -$1,900,000+($680,000 - $140,000)(P/A,15%,6) =

$143,630

Determine how sensitive the decision to invest in the system is to the

estimates of initial investment cost and annual savings.
 Spreadsheet Tool
Spreadsheets are very useful in performing sensitivity analysis.
 Formulas easily reflect changes in parameter values.
 Tables and plots can provide quick answers and visual cues to the effect of
changes.
 A spider plot can be especially useful in sensitivity studies.
 It can be useful to examine more than one alternative on a plot, or to examine
sensitivity of incremental cash flows.
 Spider Diagram

[Note that the steeper the curve, the more sensitive is the PW to the factor.]
 Sensitivity Analysis

Changing the value of more than one factor at a time.

 To this point we have only looked at changes in one factor at a time.
 In reality, each factor considered can change, so it is useful to look at the effect
of simultaneous changes in factors of interest.
 One way to accomplish this is to use the Optimistic-Most Likely-Pessimistic
(O-ML-P) technique.
 Sensitivity Analysis

Optimistic-Most Likely-Pessimistic

 Establish optimistic (the most favorable), most likely, and pessimistic (the least
favorable) estimates for each factor.
 The optimistic condition, which should occur about 1 time out of twenty, is
when all factors are at their optimistic levels. Similarly for pessimistic
condition.
 The most likely condition should occur roughly 18 times out of 20.
 Perform EW calculations under each condition for insight into the sensitivity of
the solution.
 The results can be seen on a spider plot for further insight.
 Example 3 – Crane Investment

Consider investment in a new crane. Assume a MARR of 8%.

Estimation Condition
Optimistic (O) Most Likely (M) Pessimistic (P)
Investment, I $240,000 $270,000 $340,000
Useful life, N 10 yr 8 yr 5 yr
Market value, MV $20,000 $15,000 $8,000
Annual revenues, R $100,000 $80,000 $50,000
Annual expenses, E $10,000 $15,000 $20,000
 Example 3 – Crane Investment

Considering O-ML-P for I and R (fix E, MV, and life at their ML levels).
Value in each cell is the PW for the project.

Investment, I
Revenues, R Optimistic (O) Most Likely (M) Pessimistic (P)
Optimistic, (O) $256,568 $226,568 $156,568
Most Likely, (M) $141,636 $111,636 $41,636
Pessimistic, (P) -$30,764 -$60,764 -$130,764

This suggests that perhaps some additional effort should be place on getting refined
estimates of revenues. Of course, the complete study needs to consider the other factors.
 Example 4 – Transmission Housing

 Given: Financial facts

o Known with great confidence
 Required investment = $125,000
 Project Life = 5 years
 Income tax rate = 40%
 MARR = 15%
o Unknown but predictable (most likely values)
 Unit variable cost = $15 per unit
 Number of units = 2,000 units
 Unit Price = $50 per unit
 Salvage value = $40,000
 Fixed cost = $10,000/yr
 Find: Determine the acceptability
of the investment.
 Example 4 – Transmission Housing

Deviation −20 −15 −10% −5% 0% 5% 10% 15% 20%

% %

Unit $57 $9,99 $20,05 $30,111 $40,169 $50,225 $60,28 $70,33 $80,39
9 5 1 7 3
price

Demand 12,010 19,04 26,088 33,130 40,169 47,208 54,247 61,286 68,325
9

Variable 52,23 49,21 46,202 43,186 40,169 37,152 34,135 31,118 28,101
6 9
cost

Fixed 44,191 43,18 42,179 41,175 40,169 39,163 38,157 37,151 36,145
5
cost

Salvage 37,78 38,37 38,974 39,573 40,169 40,765 41,361 41,957 42,553
2 8
value
Example 4 – Transmission Housing

Devia −2 −1 −10 −5 0% 5% 10 15 20
tion 0 5% % % % % %
%
Unit $57 $9, $20, $30, $40, $50, $60 $70 $80
99 055 111 169 225 ,281 ,337 ,39
price
9 3

Dema 12, 19, 26,0 33,1 40,1 47,2 54, 61,2 68,
010 04 88 30 69 08 247 86 325
nd
9

Varia 52, 49, 46,2 43,1 40,1 37,1 34,1 31,1 28,1
236 219 02 86 69 52 35 18 01
ble
cost
Fixed 44, 43, 42,1 41,1 40,1 39,1 38,1 37,1 36,1
191 185 79 75 69 63 57 51 45
cost
Salva 37, 38, 38,9 39,5 40,1 40,7 41,3 41,9 42,
782 378 74 73 69 65 61 57 553
ge
value
 Summary
25

 For a project to be considered, breakeven conditions must be identified.

 All project will have some form of variability and the impact of these variation
is known as sensitivity analysis.
 Recognizing factors that contribute to highly sensitive variation can be further
studied to have better and successful implementation.