Sensitivity analysis
A sensitivity analysis studies the impact of specified variations in key factors on the initially-calculated NPV. The initial point for a sensitivity analysis is the NPV using the most likely value or best estimate for each key variable. Taking the resultant base case NPV as a reference point the aim is to identify those factors which have the greatest impact on the profitability of the project if their realised values deviate from expectations. This intellect signals to managers where they should arrange to focus resources in order to secure favourable outcomes. Problems with sensitivity analysis comprise the following
- It deals with changes in isolation as well as tends to ignore interactions between variables. For instance advertising may alter the volume of output as well as influencing price and price and volume are usually related.
- It assume that specified changes persist all through the project lifetime - example a postulated l0% change in volume may be projected for each year of operation. Actually variations in key factors tend to fluctuate randomly.
- It may perhaps reveal as critical factors over which managers have no control thus offering no guide to action. However it may still help to clarify the risks to which the project is exposed.
- It doesn't provide a decision rule example it doesn't indicate the maximum acceptable levels of sensitivity.
- It provides no indication of the likelihood of the variations under consideration. Difference in a factor which is potentially devastating but has a minimal chance of occurring provide little cause for concern.