13.4 Sensitivity analysis

Question 1

What is sensitivity analysis?

Answer 1

A tool for quantitative risk assessment which predicts the outcome of a decision by ascertaining the most critical variables and their effect on an investment decision.

Question 2

What is the methodology for sensitivity analysis?

Answer 2

1 Specify a base situation and calculate net present value
2 Only accept projects generating net preset value
3 Calculate percentage change in each variable that would affect NPV
4 Calculate sensitivty margin as: (NPV / percentage change) x 100

Question 3

What are the advantages of sensitivity analysis?

Answer 3

• based on a simple theory and easily understood
• identifies areas and estimates crucial to project success
• allows investment decisions based on various possible outcomes
• commonly used (e.g. in the public sector)

Question 4

What are the disadvantages of sensitivity analysis?

Answer 4

• only one variable is changed at a time, which is unlikely to happen in the real world
• may produce too much information and therefore overwhelm the decision maker
• only provides information to help managers make decisions - does not actually make the decision itself