Finance Paper: Designing Financial Applications

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March 3, 2014

finance-paper

Discounting and sensitivity analysis

There are numerous method used to assess the suitability and feasibility when launching some products in the market. This is mostly done through analysis of the cash flow, in this paper, will look at the methods that takes into consideration the time value of money while still considering other aspects and uncertainty affecting the launch (Bell, 1990).

Discounting method

Discounting methodology is a procedural process dealing with an investment or project analysis of cash flow. The most commonly known method under this method are  modified
internal rate of return ( MIRR) and present net value index. This method is advantageous in comparison with non-discounting due to its emphasis on the time value of money. This is preferably important in projects mostly in the engineering sector. This is owing to the long duration requiring the projects taking vastly deferring of payment. Using this discounting methodology helps to analyze this prolonged projects payment time, leading to inconsistency is eradicated (Fields, 2002).

Methodology

Through the use of net present value (NPV) method, there is comparison of future payment present value with that of the capital employed or initial investment. The present value of the investment is determined from the projected surplus (Fields 2002). If the Net Present Value is greater than zero or have adjusted positively, then it indicates surplus generation from the project. This is because of consideration and inclusion of risk premium in discounting rate. Despite the investor not receiving the cash immediately, the extra gain is reflected in the future surplus present value of the investment or project cash flow (Bell, 1990).

Internal rate of return (IRR) on the other hand is similar to the net present value (NPV) method, however, both methods yields different results. This as a result of equating the net present value with zero resulting to return rate earned on the project initial capital over the project period following recoupment of capital outlay initially. The internal rate of return is more complex despite its easy mathematical calculation, under normal circumstances there is a try and error mode finding solution which is relatively tricky. The main objective of this method is aimed at the determination of percentage return on capital employed.

Discounting method flaws

This is a method that is characterized by some flaws like reinvestment assumption, non-additive
internal rate of returns, and multiple internal rate of returns possibility in addition to conflicting advice possibility with net present value.

Sensitivity analysis

This is the study on output uncertainty in a mathematical system or model which is differently apportioned from output sources, which are also uncertain. Sensitivity analysis involves system robustness testing; enhance the relationship between output and input variables within the model and significant reduction of uncertainty according to Fogiel, 1994. This is done through error searching tactics, model simplification, enhanced communication within the system and input factor optimization.

Core methodology

Sensitivity analysis is developed with the aim of addressing constraints which is done through distinguishing of sensitivity measure. This measure is based on elementary effects, partial derivatives and variance decompositions. The first step is uncertainty input quantification through probability distribution and ranges. Then output analysis model is identified. That is ideally targeting of interested uncertainty to be addressed by the model. Thereafter, the model is run using experiments design dedicated to a specific chosen method and uncertainty output. Lastly, through the use of the output model to perform sensitivity measures calculation of interest (Fields, 2002).

The mode of analysis will make use of tabular mode of analysis. This due to its simplicity and ability of clear determination of the relationship of variables and comparison of the data used (Bell, 1990).

Am introducing two products into the market the first products is product A and the other is product B. Product A will be a zero rated product while product B will be a taxable one. I will conduct the feasibility of both product and determine which one to invest in considering all factors and uncertainty aspect coming into play. The analysis is based on forecasted cash flow over a period of five years…”

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