Question

Risk and Uncertainty 12) Briefly explain payback period, breakeven analysis, sensitivity analysis, and risk-adjusted discount rates. Explain why and how each is an approach to incorporating risk and uncertainty into the analysis.

Answer 1

-- Payback method: Payback period refers to a capital budgeting concept that refers to period of time which is needed for a project to generate a return on investment that cover the original investment made by a company on the initial project cost. This is calculated by dividing the amount of the investment by the projected cash inflow per year. A shorter payback period equates to a higher return on the capital investment. Most of the companies have a maximum acceptable payback period and thus consider those projects whose payback period is normally less than the target number of years. However this method ignores cash flows beyond the payback period, thus ignoring the "profitability" of a project. Moreover overlooks the costs of capital such as interest factor which is a vital consideration in making sound investment decisions

-- The break-even analysis refers to a financial tool that helps the management to determine at what stage the organisation, or a new service or a product, would be profitable. The break-even analysis is computed by dividing the total fixed costs in the process of production with contribution per unit (i.e. price per unit minus variable costs). The calculation depicts the maximum profit on a specific product/service which can be generated; and acts as a comprehensive guide in fixing the targets in terms of revenue or units.

-- Sensitivity analysis refers to a financial model which determines how target variables are impacted with the changes in other variables termed as input variables. It helps in the identification of important variables that have main influence in the analysis of cost and benefits of the project. The expenses, demands, operating costs and legal costs, financial benefits and revenues are included in this stage

-- The risk-adjusted discount rate refers to the rate to be applied in the computation of the present value of a risky investment, thus represents the requisite return on investment. Financial analysts use the method to discount the cash flows of firm to their present value and determine the risk which an investor can accept for a specific investment.