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Value of Information

Now that you know the project could be thrown badly off course by a poor estimate of sales, you might like to see whether it is possible to resolve some of this uncertainty. Perhaps your worry is that the store will fail to attract sufficient shoppers from neighboring towns. In that case, additional survey data and more careful analysis of travel times may be worthwhile.

On the other hand, there is less value to gathering additional information about fixed costs. Because the project is marginally profitable even under pessimistic assumptions about fixed costs, you are unlikely to be in trouble if you have misestimated that variable.

Limits to Sensitivity Analysis. Your analysis of the forecasts for Finefodder`s new superstore is known as a sensitivity analysis. Sensitivity analysis expresses cash flows in terms of unknown variables and then calculates the consequences of misestimating those variables. It forces the manager to identify the underlying factors, indicates where additional information would be most useful, and helps to expose confused or inappropriate forecasts.

Of course, there is no law stating which variables you should consider in your sensitivity analysis. For example, you may wish to look separately at labor costs and the costs of the goods sold. Or, if you are concerned about a possible change in the corporate tax rate, you may wish to look at the effect of such a change on the project`s NPV. One drawback to sensitivity analysis is that it gives somewhat ambiguous results. For example, what exactly does optimistic or pessimistic mean? One department may be interpreting the terms in a different way from another. Ten years from now, after hundreds of projects, hindsight may show that one department`s pessimistic limit was exceeded

twice as often as the other`s; but hindsight won`t help you now while you`re making the investment decision.

Another problem with sensitivity analysis is that the underlying variables are likely to be interrelated. For example, if sales exceed expectations, demand will likely be stronger than you anticipated and your profit margins will be wider. Or, if wages are higher than your forecast, both variable costs and fixed costs are likely to be at the upper end of your range.

Because of these connections, you cannot push one-at-a-time sensitivity analysis too far. It is impossible to obtain expected, optimistic, and pessimistic values for total project cash flows from the information in Table 5.2. Still, it does give a sense of which variables should be most closely monitored.