Sensitivity Analysis

Question 1

Sensitivity analysis [3]

Answer 1

Assesses how responsive the project’s NPV is to changes in the variables used to calculate that NPV.

Sensitivity analysis is one particular approach to uncertainty analysis.

The certainty equivalent approach is another; this involves the conversion of the expected cash flows of the project to riskless equivalent amounts.

Question 2

Sensitivity of any variable (%)

Answer 2

NPV of whole project/Present value of project variable

Question 2

Sensitivity Analysis, interpretation of a lower percentage

Answer 2

The lower the percentage, the more sensitive the NPV is to that project variable, as the variable would need to change by a smaller amount to make the project non-viable.

Question 3

What are the weaknesses of the approach to sensitivity analysis that requires isolated changes in key variables? [5]

Answer 3

• Isolation of Variables: Assumes other values in cash flows are unchanged, which may not align with management’s interest in combined effects of changes in multiple variables.
• Interdependency Ignored: Does not examine interdependent effects of factor interactions on uncertainty.
• Uncertainty Paradox: Introduces a paradox when looking at factors in isolation under uncertainty.
• Lack of Control: Critical factors may be beyond managers’ control.
• No Decision Rule: Does not provide a decision rule; managers must define parameters for investment acceptability given the uncertainty.