Application of Sensitivity Analysis in Shipyard Investments

8/4/2019 Application of Sensitivity Analysis in Shipyard Investments

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Application of sensitivity analysis in shipyardinvestment projectsR. ~ a ~ n a k ~ ,. E. Okudanl, M . ~ u n e r "'De pa rtm ent of Business Adn~inistratzon,G eb ze Institute of Technology. Kocaeli - Turkey.2 ~e p a r t t n e r z tf Na val Architecture Engineering,Yildiz Tech nical University, Istanbzil - Turkey.AbstractInvesting on shipyard and shipbuilding requires considerable amount ofexpenditure. This expenditure is expecteri to produce income after thecom ple tion o f the investm ent. In general, income is directly proportional to risk.Risk yields either a high income or a loss. Therefore, critical variables, whichm ay have an affect on the investment outcome should be determined, and furtheranalyzed. Sensitivity analysis is one of the tools used for this purpose. Thiswork presents a sensitivity analysis application on inflation rate for a shipyardinvestment project where inflation values experienced in Turkey over twodecades were used.1 IntroductionSensitivity analysis is one of several techniques that can be used for riskanal ysis. It is particularly useful when effects of various variables -such as thedisc ou nt rate, the lo an interest rate. the project cost and the sales volume - on thema in criterion of the analysis are of interest. The sensitivity analysis isapp lica ble to an y variable that is expected to affect the outcom e. However. aprioritization a mo ng the variables may be necessary wh en resources are scarce.N e t presen t valu e (N PV ) and!or internal rate of return (IRR) are generally usedas criteria. N P V is the total value of differences between discou nted inco mes andlosses of the investment. It is the current mon etary value of the investme nt's ne texpected income. Discount rate is the interest rate used in calculating the presentvalue of expected yearly benefi ts and costs [ l ] . The discount rate is used to


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obtain the discount factors, which translates expected benefits or costs in anygiven future year into present value terms. The discount factor is equal to l/ ( l+ i) 'where (i) is the interest rate, and (t) is the investment's economic life [ l ] .Internal rate of return is the discount rate that sets the net present value of thestream of net benefits equal to zero. Annual cash inflows calculated by this ratewill produce a total value equal to investment's current value. For investmentdecisions governed by the internal rate of return, the calculated rate of return iscompared to the cost of capital. Let's assume that the interest rate for the loanacquired for the inves tment is 1 0% . If the internal rate of return is bigg er than10% , the in vestm ent is profitable; otherwise it is consid ered to be a loss [2].2 Risk assessment of investment projectsIn general, the following steps are taken for assessing the risk of investmentprojects [3].i. Th e predicted cash flow is discounted to on e rate or figure, such as th eperiod of repaym ent, internal rate of return, or net present value et c.ii. This rate or figure is compared to the net present value of the investmentexpend itures or to an acceptable rate of return.iii. Investm ent proposal is accepted if the calculated fig ure or rate is better thana threshold value.Generally, a range is considered for the threshold. If the predicted pro ject returnis higher than the maximum point, the proposal is accepted; and if it is lowerthan the minim um point, the proposal is rejected. For any valu e in betw een , amore detailed analy sis on various project criteria should be considered.In addition to common investment risk factors such as inflation, compulsorychanges in the capacity utilization and loan interest rate; all investment projectsare subject to risk inherent to their nature: for example, the risk of storm and seaaccidents in marine transportation, and drought in agricultural investments.Various industry sec tors have different risk levels changing based on technology,competition and market conditio ns. Uncertainty, hornever, affects all projectsregardless of their sector, and on many criteria such as the protit rate. Thesensitivity analysis is one of the efficient tools that will help the investor decideabout future outconles of the investment under risk and uncertainty, andencourage or discourage investing [4].


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3 Use of sensitivity analysis in TurkeyThe sensitivity analysis has not been used adequately for investment decisionanalysis in Turkey. Mostly, the financial strength of the investor is seen veryimportant. Accordingly, creditors -banks in general- analyse the accountin grecords o f the investor before any amo unt of investment fund is issued. Som ealso include technical analysis of the project to their process of cred it evaluation.The Technology Developnient Foundation of Turkey, which was established tosponsor technology projects [j]. ses a scoring system that integrates economicand te chnolog ic efficiency of the project. State sponsored projects are evaluatedbased o n social benefits . Therefore, the financial analysis is not regarded asimpor tant a s the social benefit [ 6 ] .For the investor, however, the investment decision is more critical due to theuncertainty and hence risks, particularly in Turkey. Therefore, for anyinvestment project, feasibility analysis and detailed risk analysis should be done.Analyz ing risk may be accomplished by sensitivity analysis in three steps: Thefirst step is to dete rm ine risk factors affecting the project. T he possibleinve stm ent risks are as fo'llows [ 6 ] .

Interest rate riskCredit riskFinancial riskW ork force riskMark et share and m arket flow riskRe-investment riskTechn ological riskGeographical & political riskCountry and transfer riskInflation riskEx cha nge rate risk

Among risk factors mentioned above. market f low and re-investment r isk ma]require explanation. Mark et flow is the transfer of the market to other locationsfor various reasons. An example could be the loss of shipbuilding market byWestern countries equipped with advanced technologies to Eastern Europe andFar-East countries because of the higher cost of labor in the West. Re-investment risk is the tendency to explore other investment opportunities due toincreased uncertainty.While some of these factors significantly affect the result of an investmentproject, some can be ignored. Determining the most influential ones andanalyzing them will save time: and help analysts to reach the expected resulteasily. The determination of most significant risk factors of the project is thesecond step. For this purpose, the pre-determined analysis criterion - for


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Due to the differences in the predicted and experienced inflation rates, theplanned 75% capacity utilization should be changed, in order to keep theinvestment profitable. These necessary levels of capacity utilization arecalculated fo r experien ced values of inflation and are shown in Tab le 1 . For thisanalysis, purc hasing a nd selling prices are kept constant. The reason for this istw ofo ld: First of all, the sales price fo r boats 1s kept constant. Becau se they areluxury products, and have a market niche where there is increasing competition.Therefore. an increase in sales price may affect the sales volume, and hence thecapacity utilization.Secondly, production cost in boat building is mainly affected by the labor cost.which is rather low in Turke y when exchang e rates are accounted for .

InvestmentLife

19881989199019911992199319941995l996

Predicted Predicted R eal RealInflation

Rate

0,0460,0680,0890.1110.1330.1540.1760.198

Capacity Inflation CapacityUtilization Rate UtilizationRate 1 Rate

l

0.75 -0.021 l 0.760.75 0.281 1 0.750,75 l 0.266 1.10.75 -0,055 ' 1.060.75 0.036 1.010.75 -0,03 ' 0.920.75 -0.224 0.770.75 0,246 I 0.78

Table 1 . Inflation and Capacitj I!tiiizat~on Rates

Figure 2 demonstrates the adjustment level necessary while managing thecapacity in terms o f predicted and experienced capacity utilization rate ratio.Th is ratio needs careful analysis. As can be seen in Table 1, this ratio has biggervalues when inflation increases as for years of 1990 and 1995, which wouldindicate a high er capa city utilization rate. A s seen in Table 1. this adjusted ratemay be more than l o o % , which is not attainable without additional investment.W hen inflation is havi ng negativ e values th e capacity utilization rate m ay n ot bedecreased for higher revenues.


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Table 2 shows the NPV calculation for predicted expenses and revenues basedon 75% capacity utilization rate and predicted inflation rates. This calculatio nshows a net gain of 17,828,470 for an investment amoun t of 8,3 61,4 16 in U SD .Let's assume that the investor has found the investment proposal profitable anddecided to invest in this projec t. In this case, he would be loosin g money w heninflation rate increases and the current capacity level does not permit moreproduction, even if he can sell whatever amo unt is produced. The refore. heneeds to further analyze how the NPV changes for various levels of differencesin capacity utilisation rate. Table 3 shows this analysis, for 20 % less, 10% less,1 0 % h o r e and 20% more of predicted inflation values.

1988 1989 1990 1 991 1992 1993 1994 1995 1996 1997 1998 1999Years

Table 2 . Predicted Cash Flow for the Investment


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Table 3. Sensitivity Analysis of the Investment for Different Inflation Rates.In Table 3, i t can be s een that changes in the inflation rate ha ve a h uge effect onthe NPV for this investment. The values for K P V are in the range o f 14,758.509and 32,819,193. Th e difference is more than 50%. Also, it should beremembered that the investment is not sensitive just to inflation rate increases.Therefore, sensitivity analysis should be taken further to include other riskfactors and their two-w ay or three-way interactions as well.5 ConclusionTurkey has been experiencing high levels of inflation for the last three decades.The level of i t has been as high as 150% and down to 65%. However , whenvalues are reviewed care full^, i t could be seen that in US D the inflation has beenqu ite different than what it had been with TR L. It is much less in US D .Ilowever. i t ha s been unstable . T h ~ s as affected the investors In the past .Likewise, i t will h ave effects in the future .T he biggest prob lem with unstable inflation is that it almost m ake s it impossibleto predict the outcome of the investment, and therefore, many investors looseinterest in investing. How ever, sensitivity analysis gives thoroug h und erstandin gfor what might hap pen fo r risk factors under study. For the case included in thestudy, although the investor has accepted to invest for a N PV of 17,838.470USD. his actual gain has been 32.819.193 USD for the same amount ofinvestment. Th eref ore, it can be concluded that instability o f inflation ra te canhav e positive and negative effects. Investors shou ld utilize this information witha careful study o f risk factors using sensitivity analysis.


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[91[l 01 Central Bank Repub lic of Turkish, Exchange Rates from 19 80 to 20 00 .

LaCivita, C.J. Economic Analysis Handbook, Defense Resources,Management Institute, 1997. http:::\\,eb.nps.11avv.mi:-drmi:Hatipoglu, Z. Introduction Business Finance, Sedok, istanbu l, 1997.Sogancilar, E. Risk Analysis in Agricultural Investment Projects, StatePlanning Foundation, Ankara, 1986.Poulingen, L.Y. isk Analysis In Project Appraisal, International Bank forReconstruction and Development, USA, 1970.The Technology Developm ent Foundation of Turkey, Product Developm ent,Research and Development Support Evaluation Fonn, 1999.Scott, D.L. Und erstand ing and itilar~aging Investment Risk & Return,McG raw-Hill Book Com pan y (UK), England, 1990.Project Ana1,vsis Techniques, State Planning Foundation, 1996,u ww.d~t.gov.tr'dpt~~eble1~iitu~~96~ps~-a1~ali~6.l~t1~~1Kay nak, R. Risk An alysis in Investment Projects and an Application- MB AThe sis, Gebze Institute o f Technology, Kocaeli, 1 999 .DIE. Con sum er Price Indexes from 1980 to 200 0.

Application of Sensitivity Analysis in Shipyard Investments

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