Question

What is the main purpose of sensitivity analysis in evaluating projects?

Answer 1

What is Sensitivity Analysis?

Sensitivity Analysis is a method or mechanism that is used in modeling to evaluate how the different values of a set of independent variables affect a particular dependent variable under certain specific conditions. In other words, it is a technique that is used to determine how independent variable values will impact a particular dependent variable under a given set of assumptions. It is applied and used in a wide range of fields, that range from geography and biology to engineering and economics. So it can be used from planning a family vacation to the decisions at corporate level. It is also called as what – if analysis
For Instance, what effect changes in interest rates would have on a bond’s price given the various interest rates.

Basic purpose of sensitivity analysis in evaluating projects

Sensitivity Analysis is used in evaluating a project by considering the effect of change in one variable (for instance interest rate or discount ) on the Cash inflows of different projects.

In evaluating a project, Sensitivity analysis captures the attention of management on the critical variable. It evaluates the effect of a change in one variable, while the others remaining constant.

The method of Sensitivity analysis investigates how projected performance will vary with a change in the key assumptions on which capital project projections are based. The Net Present Value of a project is based upon a series of cash flows and the discount factor. Both these factors depend upon many variables such as sales revenue, input cost, competition etc.

Given the level of all these variables, there will be a set of cash flows and Net Present Value of the proposal. If any of these variables changes, the value of NPV will also change. In other words, the value of NPV is sensitive to all these variables.