SENSTIVITY ANALYSIS

SENSITIVITY ANALYSIS

FINANCIAL MANAGEMENT/PROJECT MANAGEMENT

•     MEANING

1.       USED TO DETERMINE HOW INDEPENDENT VARIABLES VALUE WILL IMPACT A PARTICULAR DEPENDENT VARIABLES UNDER A GIVEN SET OF ASSUMPTIONS

2.       ALSO KNOWN AS WHAT IF ANALYSIS

3.       CAN BE USED FOR ANY ACTIVITY OR SYSTEM

4.       WORKS ON THE SIMPLE PRINCIPLE CHANGE THE MODEL AND OBSERVE THE BEHAVIOUR

5.       IS A TECHNIQUE FOR INVESTIGATING THE IMPACT OF PROJECT VARIABLES ON THE BASE CASE ( MOST PROBABLE OUTCOME SCENARIO)

•     THE PURPOSE 

1.       TO HELP THE IDENTIFY THE KEY VARIABLES WHICH INFLUENCE THE PROJECT COST AND BENEFITS STREAMS

2.       TO INVESTIGATE THE CONSEQUENCES OF LIKELY ADVERSE CHANGES IN THESES KEY VARIABLES

3.       TO ASSESS WHETHER PROJECT DECISIONS ARE LIKELY TO BE AFFECTED BY SUCH CHANGES

4.       TO IDENTIFY THE ACTIONS THAT COULD MITIGATE POSSIBLE ADVERSE EFFECTS ON THE PROJECT

•     SENSITIVITY ANALYSIS

•     IN EVALUATION OF AN INVESTMENT PROJECT:

1.       CASH FLOWS ARE FORECASTED AND THESE DEPEND ON EXPECTED REVENUE AND COSTS

2.       EXPECTED REVENUE IS A FUNCTION OF SALES VOLUME AND UNIT SELLING PRICE

3.       SALES VOLUME WILL DEPEND ON THE MARKET SIZE AND FIRMS’ MARKET SHARE

4.       COSTS INCLUDE VARIABLE COST ( DEPENDENT ON SALES VOLUME ) AND FIXED COST

•     THE NET PRESENT VALUE OR INTERNAL RATE OF RETURN IS DETERMINED BY ANALYZING AFTER TAX CASH FLOW ARRIVED AT BY COMBINING FORECAST OF VARIOUS VARIABLES

•     THE RELIABILITY OF NPV AND IRR OF THE PROJECT WILL DEPEND UPON THE RELIABILITY OF THE FORECAST OF VARIABLES OF THE FORECASTS OF VARIABLES UNDERLYING THE ESTIMATES OF NET CASH FLOWS.

•     SENSITIVITY ANALYSIS IS A WAY OF ANALYZING CHANGES IN THE PROJECT ‘S NET PRESENT VALUE OR IRR FOR A GIVEN CHANGE IN ONE OF THE VARIABLE AND IT INDICATES HOW SENSITIVE A PROJECT’S NPV OR IRR IS TO CHANGE IN PARTICULAR VARIABLES,

•     STEPS

•     IDENTIFICATION OF ALL THOSE VARIABLES WHICH HAVE AN INFLUENCE ON THE PROJECT’S NPV OR IRR

•     DEFINITION OF THE UNDERLYING RELATIONSHIP BETWEEN THE VARIABLES

•     ANALYSIS OF THE IMPACT OF CHANGE IN EACH OF THE VARIABLE ON PROJECT’S NPV

•     STEPS

•     COMPUTE THE PROJECT’S NPV OR IRR FOR EACH FORECAST UNDER THREE ASSUMPTIONS :

1.       PESSIMISTIC

2.       EXPECTED

3.       OPTIMISTIC

•     WHAT IF ANALYSIS

1.       WHAT IS NPV IF VOLUME INCREASE OR DECREASE

2.       WHAT IS NPV IF VARIABLE COST OR FIXED COST INCREASES OR DECREASES

3.       WHAT IS NPV IF THE PROJECT IS DELAYED OR OUTLAY ESCALATES

4.       ALL THESE CAN BE ANSWERED WITH THE HELP OF SENSITIVITY ANALYSIS

5.       SENSITIVITY ANALYSIS EXAMINES THE SENSITIVITY OF THE VARIABLES UNDERLYING THE COMPUTATION OF NPV OR IRR

6.       CAN BE APPLIED TO ANY VARIABLE WHICH IS INPUT FOR THE AFTER TAX CASH FLOWS

•     PROBLEM

•     MR A IS CONSIDERING TWO MUTUALLY EXCLUSIVE PROJECTS X AND Y

•     ADVISE HIM ABOUT THE ACCEPTABILITY OF THE PROJECT

•     SOLUTION PROJECT X

•     SOLUTION PROJECT Y

•     BENEFITS OF SENSITIVITY ANALYSIS

1.       HELP THE DECISION MAKER TO IDENTIFY THE VARIABLES WHICH AFFECT THE CASH FLOWS FORECAST AND HELP HIM UNDERSTAND THE INVESTMENT PROJECT IN TOTALITY

2.       INDICATES THE CRITICAL VARIABLES FOR WHICH ADDITIONAL INFORMATION MAY BE OBTAINED AND HELP THE DECISION MAKER IN IDENTIFICATION OF WEAK POINTS AND TAKING QUICK ACTIONS

3.       HELPS TO EXPOSE INAPPROPRIATE FORECAST AND GUIDE THE DECISION MAKERS TO CONCENTRATE ON RELEVANT VARIABLES

•     LIMITATION

1.       DOES NOT PROVIDE CLEAR CUT RESULT

2.       THE TERM OPTIMISTIC AND PESSIMISTIC COULD MEAN DIFFERENT THINGS TO DIFFERENT PERSONS

3.       FAILS TO FOCUS ON THE INTERRELATION BETWEEN VARIABLES, FOR EXAMPLE SALES VOLUME MAY BE RELATED TO PRICE AND COST. A PRICE CUT MAY LEAD TO HIGH SALES AND LOW OPERATING COST