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Sensitivity Analysis

The way of analyzing change in the project’s NPV (or IRR) for a given change in one of the variables is known as Sensitivity analysis. How sensitive a project’s NPV (or IRR) is to changes in particular variables is indicated under Sensitivity Analysis. The more sensitive the NPV, the more critical is the variable. It analyzes the Identification of all those variables, which have an influence on the project’s NPV (or IRR). Sensitivity analysis gives the Definition of the underlying (mathematical) relationship between the variables. It also elucidates the analysis of the impact of the change in each of the variables on the project’s NPV.

In the evaluation of an investment project, we work with the forecasts of cash flows. Forecasted cash flows depend on the expected revenue and costs. Further, expected revenue is a function of sales volume and unit selling price. Similarly, sales volume will depend on the market size and the firm’s market share. Costs include variable costs, which depend on sales volume, and unit variable cost and fixed costs. The net present value or the internal rate of return of a project is determined by analyzing the after-tax cash flows arrived at by combining forecasts of various variables. It is difficult to arrive at an accurate and unbiased forecast of each variable. The reliability of the NPV of variable underlying the estimates of net cash flows. To determine the reliability id the project’s NPV or IRR, we can work out how much difference it males in any of these forecasts goes wrong. We can change each of the forecasts, one at a time to at least three values: pessimistic, expected, and optimistic. The NPV of the project is recalculated under these different changing each forecast is called sensitivity analysis.

The decision-maker, while performing sensitivity analysis, computer the project’s (or IRR) for each forecast under three assumptions: (a) pessimistic, (b) expected, and (c) optimistic. It allows him to ask ‘’what if’ question. For example, what (is the NPV) if volume increase or decreases? What (is the NPV) if variable cost of fixed cost increases or decreases? What (is the NPV) if the selling price increases or decreases? That (is the NPV) if the project is delayed or outplay escalate or he questions can be answered with the help of sensitivity analysis. It examines the sensitivity of the variables underlying the computation of NPV or IRR, rather than attempting to quantify risk. It can be applied to any variable, which is an input for the after-tax cash flows.