Sensitivity Analysis:
It provides information as to how sensitive estimated project parameters. Sensitivity analysis takes care of estimation errors by using a number of possible outcomes in evaluating a project. The sensitivity analysis provides at least 3 different cash flow estimates under the following assumptions:-
(i) The Worst (Most pessimistic)
(ii) The Expected (Most likely)
(iii) The best (Most optimistic)
The NPV/IRR of project is calculated under these different assumptions. This Method of calculating NPV/IRR by changing each forecast is called sensitivity analysis. The actual selection of project under above assumptions depends on the decision maker's attitude towards risk.
Another way to look sensitivity analysis is that "Sensitivity analysis is a way of analyzing change in the project's NPV/IRR for a given change in one of the variable". It indicates how sensitive a project's NPV/IRR is to changes in particular variable. The more sensitive the NPV, the more critical is the variable. It can be applied to any variable, which is an input for the after tax cash flows.
Sensitivity analysis is a variation of the break-even analysis. One can ask what shall be the consequences if volume or price or cost changes. In capital budgeting decision one more variable i.e. life of the project is also included for sensitivity analysis. In other words, we can say, how much lower (Break even value) can the sales volume or sales price or project life become .or how much higher, costs (Break even value) can be incurred before the project becomes unprofitable in terms of NPV.
Here break-even point means a point where NPV is zero. The decision rule is, higher the Margin of Safety (MOS), lesser the sensitivity of the variable.
Margin of safety for variable =
Difference in Break – even value and projected value of variable * 100 / projected value of variable
The simple sensitivity analysis assumes that the variables are independent. In practice, the variables will be interrelated. The decision maker can develop some plausible scenarios. For example, by reducing unit-selling price, it may be possible to increase volume. It is also called as "Scenario Analysis". Sensitivity analysis, in spite of being crude, does provide the decision maker with more the one estimate of the projects outcome and, thus, an insight into the variability of the returns.