5 Sensitivity Analysis. Illusions Ltd is a small firm specialising in the creation of special effects for the film and television industry. Management is considering an investment proposal to upgrade existing services in order to meet contractual obligations and improve competitiveness. New equipment will cost £150,000;

installation costs are estimated at £10,000. Building alterations and modifications are estimated to cost £90,000. It is anticipated that £20,000 will be received from the disposal of old equipment and £5,000 will need to be invested in additional working capital in the form of increased stock holdings over the life of the project.

Additional annual running costs (staffing, consumables, maintenance, and power)

are estimated at £55,000, including depreciation of £15,000.

Overall, the scheme will generate increased income of £80,000 per year. The project’s life is expected to be 10 years and the required rate of return on the project is 10 per cent. Residual values will be zero. Management has set a maximum acceptable payback period of six years for projects of this type.
For ease of reference the relevant base case data is reproduced below:
1. Relevant Annual Cash Flows £
Increased annual revenue 80,000 – Increased annual running costs 55,000 = Operating surplus (profit) after depreciation 25,000 + Depreciation 15,000 = Operating cash inflows 40,000