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When used in cost-volume-profit analysis, sensitivity! Analysis
Sensitive analysis permits the decision maker to measure the effects of errors in certainty equivalents, which are estimated amounts developed by the best means available and assumed for purposes of a given decision model to be certain. The decision model then may be evaluated by changing certain data variables (certainty equivalents) critical to the success of the entity and observing the outcomes. This analysis allows the decision maker to quantify the effects of forecasting or prediction errors and to identify the most critical variables. For example, with respect to breakeven analysis, a firm might make computations using several different estimates of what fixed costs are expected to be. These calculations indicate how sensitive the results are to changes in fixed costs.
A company is evaluating the possible introduction of a new version of an existing product that will have a 2-year life cycle. At the end of 2 years, this version will be obsolete, with no additional cash flows or salvage value. The initial and sole outlay for the modified product is $6 million, and the company's desired rate of return is 10%. Following are the potential cash flows (assumed to occur at the end of each year) and their probabilities if the product is marketed:
The following interest factors for the present value of $1 at 10% are relevant:
Period 1 .909
2 .826
The project's net present value is
The expected value of the cash flows at the end of Year 1 is $4 million [(.3 x $2 million)+ (.4x $4 million) + (.3 x $6 million)], and the present value of this amount is $3,636,000 (.909 x $4 million). The expected I value of the cash flows at the end of Year 2 is $3,925,000 [(.3 x .5 x $0) + (.3 x .5 x $4 million) + (.4x .25 x $6.4 million) + (.4x .75 x $3.2 million) + (.3 x Ax $6.875 million) + (.3 x .6 x $5 million)], and the present value of this amount is $3,242,050 (.826 x $3,925,000). Hence, the NPV is $878,050 [($3,636,000 + $3,242,050) --- $6 million initial outlay].
An analyst covering Guilderland Mining Co. common stock estimates the following information for next years.
Expected return on the market portfolio 12%
Expected return on the Treasury securities 5%
Expected beta of Guilderland 2.2
Using the CAPM, the analyst's estimate of next year's risk premium for Guilderland's stock is closest to
The capital asset pricing model derives the risk premium of a particular stock (that is, the excess of the rate of return on the stock over the risk-free rate) by multiplying the stock's beta by the excess of the market rate of return over the risk-free rate. Mathematically, this is expressed as
( RStock -- RRisk-free) = x (RMarket -- RRisk-free)
For Guilderland Mining, this calculation looks like this:
(RStock -- 5% ) = 2.2 x ( 12% - 5% )
(RStock -- 5% ) = 2.2 x 7%
(RStock -- 5% ) = 15.4%
RStock = 20.4%
The prospect for the long-term profitability of an existing firm is greater when
The prospects of long-term profitability are contingent upon the industry's exit and entry barriers. The entry of new firms in market decreases the prospect for long-term profitability. When a firm operates in an industry that has a steep learning curve, it ios more difficult for new firms to enter the market. Thus, the prospects of long-term profitability are greater for an existing firm.
Companies that adopt just-in-time purchasing systems often experience
The objective of jit is to reduce carrying costs by eliminating inventories and increasing the deliveries made by suppliers.Ideally,shipments of raw materials are received just in time to be incorpotated into the manufacturing process.the focus of quality control under jit is the prevention of quality problems.quality control is shifted to the supplier.Jit companies typically do not inspect incoming goods;the assumption is that receipts are of perfect quality.suppliers are limited to those who guarantee perfect quality and prompt delivery.
