Now consider building the sensitivity analysis. You have taken a few assumptions to build your case. Some have no impact on NPV and therefore no impact on the decision. For some others, even a small change in the value of the parameter changes the NPV by an order of magnitude.

Let’s first consider the residual value of Machine B in Year 7. Perhaps your expectation will be wrong and you will sell the machine for nothing. Put 0 in cell B22 and observe the change in NPV.

Second, look at the production cost of Machine B. The cost sheet suggests that you reduce “overhead” by 3 cents. What types of overhead do you know?

Are all of these cost items supposed to be changed by changing the machine? Are these “savings” the result of a management accounting calculation, such as reducing the fixed cost allocation? Suppose you don’t reduce overhead costs.

Is this sensitive? The sensitivity analysis process is a fundamental process that leads to the validation of key (sensitive) parameters and contributes not only to the decision that may be taken, but also to the design of the system for monitoring and controlling the process: you regularly check the parameters that you have identified as sensitive.

An obvious sensitive parameter is sales volume. We devote an entire stage of the “advanced course” to this subject: the analysis of flexibility around a certain uncertainty on volumes. Just to open the discussion: if volume drops, NPV decreases and it is possible that it becomes negative if the number of units falls below the break-even point.

But the reverse could also happen. If sales volume doubles, it sounds like good news (your customers like the product, the quality is excellent, etc.) but then the problem is capacity: can you produce what you need to deliver?

In this exercise, we consider replacing one machine with another of the same capacity. If the volume is increasing, you have to find a way to introduce flexibility into the process, which we will study later in the “advanced” investment course.

This video will give you the solution to the exercise accompanying step 3 as well as some important additional information.

Once you have viewed it you can move on to the next step on capacity investment.

Click to download the accompanying solution worksheet.