Question

After completing a project analysis, an analyst should rely on which tool to make a final recommendation on the project?

NPV

Break-even analysis

Decision trees

Sensitivity analysis

Answer 1

For any Project / Major CAPEX evaluations, the three most common approaches are Payback period, Internal rate of return (IRR) and Net Present Value (NPV). However, adjacent to these techniques, there are other relevant approaches like Breakeven analysis, Decision Tree, Sensitivity Analysis, MIRR etc;

Also, there shall be cases where there can be multiple options among the Projects to choose and the firm need to choose one among them; Also, there shall be cases where these options also might not be of equal life, equal invsetment value etc;

Hence, it is always appropriate to choose multiple evaluation techniques on the Projects and finally to decide on which is more feasible option.

The payback period determines how long it would take a company to see enough in cash flows to recover the original investment.

The internal rate of return (IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero.

The Net Present Value (NPV) results in the total net cash inflows expected from a project at the present value using a discounting factor.

The Break even analysis helps to assess the potential of the Project to which it can stretch to become its value to zero. Basically, to understand the extreme factors which can influence the project to make the value to zero;

Decision Trees are precisely a Flow Chart algorithms to understand the flow of cases and to evaluate the potential chances of decision making; This can be applied when there are thumbrule situations of Yes or No and then the algorithm works on the same to reach the final decision.

Sensitivity Analysis : This is a comprehensive analysis where the firm uses this approach to define the values of the Projects incase of Ifs and Buts situations; This is generallly used where there are high probabailities of upward or downward movements of the cash flows and to understand the scenarios of Profitability or feasibility of the Projects in such cases.

To answer the question on which tool to be used to finally opt for a Project, the answer is Sensitivity Analysis and Decision Trees;

When there are no clear decision making Factors - Using Sensitivity analysis shall help in understanding the different extremes of the NPV at various senstivity points. This shall help in establishing the limits for the Project on to what extreme it can stretch and to what extreme it cannot;

Once these limits are established based on the sensitivity analysis, its a flow chart / Decision tree mechanism to evaluate the pros and cons of the project (not only from the financial profitability perspective, but also from commercial sense, operational feasibilities, etc) and can finally take decision.