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## Non-discounted Payback Period Method

Discuss about the Review on Global Sensitivity Analysis Methods.

Booli Enterprise that manufactures the electronic goods from its business location in Victoria deals with the profitable product Smart Speaker and Home Assistant (SSHA) and various other products. However, the company generates maximum amount of revenue from sales of SSHA and over the past few year the sale for the same is excellent. However, to improve the technology and add some more features to the existing SSHA model, the company is planning to manufacture a new model for SSHA. This report will focus on the profitability of the investment that will be made to manufacture new model for SSHA. For the purpose of analysis various methods like profitability index, net present value, payback period, internal rate of return will be used. Further, the report will analyse the sensitivity of the investment’s net present value with regard to the changes in the selling quantity and selling price of new SSHA model (DeFusco et al. 2015).

The non-discounted payback period method under capital budgeting does not take into consideration time value of the money. To be more specific, value of each dollar that is earned on the investment is expected to be of same value. Payback method calculates number of years required for returning the cash equal to the amount of investment. However, the method does not give any importance to the amount received after the payback period (Gorshkov et al. 2014).

Non-discounted payback period for the project –

 Year Cash inflow Cumulative cash flow 0 \$   (47,025,000.00) 1 \$       9,158,160.00 \$          9,158,160.00 2 \$     34,307,097.60 \$        43,465,257.60 3 \$     25,842,344.45 \$        69,307,602.05 4 \$     16,194,120.97 \$        85,501,723.02 5 \$     23,547,757.33 \$      109,049,480.35

Non-discounted payback period = 2 + (47,025,000 – 43.465,257.60) / (69,307,602.05 – 43,465,257.60) = 2.14 years.

It is the index that recognizes the relationship among the benefits and costs of the investment that is calculated through dividing the present value of the future cash flows by the amount of initial investment. It is also used to rank the project as it enables to quantify the value generated for per unit of the investment (Pasqual, Padilla and Jadotte 2013).

PI = PV of future cash flows / Initial investment

PI = \$ 77,573,881.43 / 47,025,000 = 1.65

Hence, the PI of new SSHA model is 1.65.

Internal rate of return or IRR is the capital budgeting metric that is used to measure the profitability of the investment. It is the discount rate at which the cash inflows of the project are equal to the cash outflows. In other words, the net cash flows become zero. IRR depends on the same formula that is used for the calculation of NPV (Goodman et al. 2013). As per the calculation in Excel, the internal rate of return for the project comes as 19.77%.

## Profitability Index (PI)

Net present value of any project is present value of all the cash flows reduced by the costs of investment. it is used for analyzing the decision of the investment for giving clear idea to the management and tell them whether to take up the project or not. If the NPV of the project comes positive then the project is accepted and if it is negative then the project is generally not taken up. From the calculation in excel the NPV of the project comes \$ 30,548,881.43 (Leyman and Vanhoucke 2016)

Sensitivity analysis is used for determining how the different values of the independent variable have an impact on the specific dependent variable under particular set of the assumptions (Ross et al. 2014). The method used for specific boundaries that is dependent on 1 or more than 1 input variables like changes in the selling prices that will be the independent variable here will have on the net present value that will be regarded as the dependent variable here. For analysing the sensitivity weightage is given to the unfavourable outcomes. The sensitivity analysis is carried ion through the below mentioned steps –

• Initially the input and output of the project is identified. As per the given question the input here will be the selling price and the output will be NPV. The impact on the NPV will be measured with the changes in the selling price. While analysing this, the other factors involved with the investment like selling quantity, initial investment and discount rate will be constant (Leung et al. 2014).
• Percentage changes in the NPV with regard to the percentage changes in the selling price will be measured
• After the above steps, sensitivity of NPV with regard to the selling price will be measured
• Finally the impact on the decision making procedure due to the sensitivity of output with regard to the input will be analysed.

From the above it can be stated that the NPV changes by 24% for every 4% changes in the selling price of new SSHA model. Therefore the sensitivity of the input with regard to the output will be 555.41%. Therefore, the output is highly sensitive to the input (Lane and Rosewall 2015). For the changes in the price from \$ 500 to \$ 1310 the NPV has been increased from -\$15,635,004.70 to \$ 184,412,844.33.

Under finance, the sensitivity analysis is generated for measuring the impact of variable that is selling quantity here has on the outcome that is net present value here. The sensitivity analysis is based on variables that have impact on the valuation that the financial model can explain through the variables like selling quantity and NPV. It differentiates the variables and records the range for the projected outcomes (Song et al. 2014). The steps for the analysis are as follows –

• As per the given question the input here will be the selling quantity and the output will be NPV. The impact on the NPV will be measured with the changes in the selling quantity. While analysing this, the other factors involved with the investment like selling price, initial investment and discount rate will be constant (Iooss and Lemaître 2015).
• Percentage changes in the NPV with regard to the percentage changes in the selling quantity will be measured
• After the above steps, sensitivity of NPV with regard to the selling quantity will be measured
• Finally the impact on the decision making procedure due to the sensitivity of output with regard to the input will be analysed (Martinsuo 2013).

From the above it can be stated that the NPV changes by 10% for every 27% changes in the selling price of new SSHA model. Therefore the sensitivity of the input with regard to the output will be 36.83%. Therefore, the output is moderately sensitive to the input. For the changes in the selling quantity from 25000 to 350,000 the NPV has been increased from \$ 22,354,148,82 to \$ 62,104,717.47

## Internal Rate of Return (IRR)

The sensitivity analysis assists in making decisions for selecting the output and input variable as the user can analyse the impact of changes in the input on the output. Based on the outcome the management can make proper decisions. However, as the sensitivity assumes that other factors will remain constant it sometimes produces irrelevant outcomes. The reason is that in practical, the other factors may not always remain same (Butler et al. 2014).

Taking into consideration all the above mentioned measures to analyse the acceptability of the project it can be concluded that Booli Enterprise shall manufacture new model for SSHA. The reason is that the NPV of the project is positive, PI of the project is 1.65, payback period is 2.14 years that is less than 5 years and IRR is 19.7% that is more than the required rate of return.

If manufacturing the new model for existing SSHA generates loss for any other product then the amount of loss shall be included in the amount of investment. If including the amount of loss results into negative NPV then the project shall not be accepted. However, if including the amount of loss results into positive NPV then the project shall be accepted.

Reference

Butler, M.P., Reed, P.M., Fisher-Vanden, K., Keller, K. and Wagener, T., 2014. Identifying parametric controls and dependencies in integrated assessment models using global sensitivity analysis. Environmental modelling & software, 59, pp.10-29.

DeFusco, R.A., McLeavey, D.W., Pinto, J.E., Anson, M.J. and Runkle, D.E., 2015. Quantitative investment analysis. John Wiley & Sons.

Goodman, T.H., Neamtiu, M., Shroff, N. and White, H.D., 2013. Management forecast quality and capital investment decisions. The Accounting Review, 89(1), pp.331-365.

Gorshkov, A.S., Rymkevich, P.P., Nemova, D.V. and Vatin, N.I., 2014. Method of calculating the payback period of investment for renovation of building facades. Stroitel'stvo Unikal'nyh Zdanij i Sooruzenij, (2), p.82.

Iooss, B. and Lemaître, P., 2015. A review on global sensitivity analysis methods. In Uncertainty management in simulation-optimization of complex systems (pp. 101-122). Springer, Boston, MA.

Lane, K. and Rosewall, T., 2015. Firms’ investment decisions and interest rates. Reserve Bank of Australia Bulletin. June quarter, pp.1-7.

Leung, B., Springborn, M.R., Turner, J.A. and Brockerhoff, E.G., 2014. Pathway?level risk analysis: the net present value of an invasive species policy in the US. Frontiers in Ecology and the Environment, 12(5), pp.273-279.

Leyman, P. and Vanhoucke, M., 2016. Payment models and net present value optimization for resource-constrained project scheduling. Computers & Industrial Engineering, 91, pp.139-153.

Martinsuo, M., 2013. Project portfolio management in practice and in context. International Journal of Project Management, 31(6), pp.794-803.

Pasqual, J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability criteria with the net present value. International Journal of Production Economics, 142(1), pp.205-210.

Ross, S.A., Bianchi, R., Christensen, M., Drew, M., Westerfield, R. and Jordan, B.D., 2014. Fundamentals of Corporate Finance: Introduction to corporate finance Chapter: 2 Financial statements, taxes and cash flow PART 2 Chapter: 3 Working with financial statements Chapter: 4 Long-term financial planning and corporate growth PART 3 Chapter: 5 First principles of valuation: TVM Chapter: 6 Valuing shares and bonds PART 4 Chapter: 7 Net present value and other investment criteria Chapter: 8 Making capital investment decisions Chapter: 9 Project analysis and evaluation PART 5 Chapter: 10 Lessons .... McGraw-Hill Education (Australia).

Song, Z., Li, Z., Wei, M., Lai, F. and Bai, B., 2014. Sensitivity analysis of water-alternating-CO2 flooding for enhanced oil recovery in high water cut oil reservoirs. Computers & Fluids, 99, pp.93-103.

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