Question

Sensitivity analysis is used to identify the variables that are most important for a project’s success. Discuss.

Answer 1

Sensitivity Analysis

- Sensitivity analysis determines how the distribution of possible NPV or internal rate of return for a project under consideration is affected consequent upon a change in one particular input variable.

- This is done by changing one variable at one time, while keeping other variables (factors) unchanged.

- This analysis is also called “what if “analysis.

- Sensitivity analysis begins with the base-case situation which is developed using the expected values for each input. If provides the decision maker with the answers to a whole range of “what if” question.

- For example, what is NPV, if the selling price falls by 5% or increase by 10%.

- This analysis can also be used to compute Break-even points.

For example sale required to meet Break-even in net present value terms

- Each variable is changed by several percentage points above and below the expected value, holding all other variable constant.

- Then a new NPV is calculated using each of these variable values.

- Finally the set of NPVs is plotted on graph to show how sensitive NPV is to the change in each variable.

After analysis the NPV or profit by using sensitivity, the company is able to identify which variables (i.e. sale price, cost, or Interest rate) is most important factor for success of a project. Thereafter, the company will start to focus and control that factor to have a successful project in future.