In the evaluation of an investment project, we work with the forecasts of cash flows. Fore casted 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 firms’ 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 different to arrive at an accurate and unbiased forecast of each variable. We can’t’ be certain about the outcomes of any of these variables. The reliability of the net present value or internal rate of return of the project will depend on the reliability of the forecasts of each variable underlying the estimates of net cash flows. To determine the reliability of the projects’ net present value or internal rate of return, we can work out how much difference it makes if any of these forecasts goes wrong. We can change each of the forecasts, one at a time, to at least three values, expected, and optimistic. The net present value of the project is recalculated under these different assumptions. This method of recalculating net present value or internal rate of return by changing each forecast is called sensitivity analysis.
Sensitivity analysis is a way of analyzing change in the projects’ values for a given change in one of the variables. It indicates how sensitive a projects’ value is to changes in particular variables. The more sensitivity of the value, the more critical is the variable. The following three steps are involved in the use of sensitivity analysis:
- Identification of all those variables, which have an influence on the projects value
- Definition of the underlying (mathematical) relationship between the variables
- Analysis of the impact of the change in each of the variables on the projects value
The decision maker, while performing sensitivity analysis computes the projects net present value or internal rate of return for each forecast under three assumptions.
- Pessimistic,
- Expected,
- Optimistic.
It all allows him to ask “what if”. For example, what if volume increase or decreases? What if variable cost or fixed cost increases or decreases? What if the selling price increase or decreases? What if the project is delayed or outlay escalates or the projects life is more or less than anticipated? A whole range of questions can be answered with the help of sensitivity analysis. It examines the sensitivity of the variables underlying the computation of net present value or internal rate of return, rater than attempting to quantify risk. It can be applied to any variable, which is an input for the after tax cash flows.
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