A manager is considering investing in a new machine that costs $2.5 million.He identifies four uncertain variables: sales,fixed costs,advertising costs and the life of the new machine.The required rate of return is 15% p.a.Given the following information,determine which variable is most sensitive to changes or errors:
A)Sales.
B)Fixed costs.
C)Advertising costs.
D)Life of machine.

Question

A manager is considering investing in a new machine that costs $2.5 million.He identifies four uncertain variables: sales,fixed costs,advertising costs and the life of the new machine.The required rate of return is 15% p.a.Given the following information,determine which variable is most sensitive to changes or errors: 
A)Sales. 
B)Fixed costs. 
C)Advertising costs. 
D)Life of machine.

Quizplus · Accepted Answer

Sensitivity analysis involves calculating the effect of changes or errors in the inputs (variables) on the output (NPV or IRR), assuming all other inputs remain constant. The variable that has the highest impact on the output when changed is the most sensitive variable.

In this case, sales directly affect revenues, which in turn affect the cash flows generated by the investment. Therefore, the sales variable is the most sensitive to changes or errors. If there is a significant difference between the expected sales and the actual sales, it will affect the cash flows and result in a different NPV or IRR than what was projected.

While fixed costs, advertising costs, and the life of the machine also have an impact on the cash flows, they are generally considered less sensitive than sales. All else being equal, a change in any of these variables will have a smaller impact on the output.

A Manager Is Considering Investing in a New Machine That