Interest Rates and Bond Valuation Sensitivity Analysis The sensitivity analysis examines how sensitive a particular variable is to a change (or changes) of other variables. In the context of NPV, sensitivity analysis refers to the sensitivity of NPV calculations to changes in the underlying assumptions. It is also known as 'what-if' analysis. Advantages Disadvantages Information for decision making - At the very least it allows the decision makers to be more informed and to know the room they have for judgmental error To Direct Search - It may lead to an indication of where further investigation might be worthwhile. The collection of data can be time consuming and expensive. If sensitivity analysis points to some variables being more crucial than others, then search time and money can be concentrated. To make contingency plans - During the implementation phase of the investment process sensitivity analysis can be used to highlight those factors that have the greatest impact on NPV. The management team can then prepare contingency plans based on the scenario. Break Even Analysis There are three types: At the decision making stage, the formal sensitivity analysis must be read in the light of subjective changes in the volume (or percentage) of the examined variables. Each variable is changed in isolation whilst all other factors remain constant. In the real world, multiple variables can change simultaneously . · The cash (flow) break even which is achieved first since it excludes depreciation · The accounting break-even is next since it includes depreciation . Finally, the financial break-even, which includes the time value of money, is achieved For a typically structured project with an initial investment and sales afterwards, this ordering will always apply. Bonds Corporations (like governments) frequently borrow money by issuing or selling debt securities called bonds. A bond is normally an interest-only loan, meaning that the borrower will pay the interest every period, but the principal will be repaid at the end of the loan period (at maturity). The interest payments are called the bond's coupons. Because the coupon is constant and paid every year, this type of bond is sometimes called a level-coupon bond, The amount repaid at the end of the loan stands for the loan principal and is expressed as the bond's face value, or par value. This is, in general, equal to $1,000 for bonds in the US and £100 in the UK. Finally, the annual coupon divided by the face value is called the coupon rate on the bond. The number of years until the face value is paid is called the bond's time to maturity. To determine the value of a bond at a particular point in time, we need to know: · The number of periods remaining until maturity . The face value
· The coupon . The market interest rate for bonds with similar features, also known as the bond's yield to maturity. Given all this information, we can calculate the present value of the cash flows as an estimate of the