A Business Encyclopedia

Sensitivity Analysis

Definition: The Sensitivity Analysis or What-if Analysis means, determining the viability of the project if some variables deviate from its expected value, such as investments or sales. In other words, since the future is uncertain and the entrepreneur wants to know the feasibility of the project in terms of its variable assumptions Viz, investments or sales change, can apply the sensitivity analysis.

Whether to accept or reject the proposed project depends on its net present value (NPV). Hence, sensitivity analysis is calculated in terms of NPV. Firstly, the base-case scenario is developed; wherein the NPV is calculated for the project based on the assumptions which are believed to be the most accurate. Then make some changes in the initial assumptions based on the other potential assumptions, and recalculate the NPV. Once the new NPV is calculated, analyze its sensitivity in terms of the changes made in the initial assumptions.

Sensitivity Analysis is very useful for a firm that shows, the robustness and the vulnerability of the project due to the change in the values of underlying variables. It indicates whether the project is worth to be carried forward or not with the help of NPV value. If the NPV value is highly sensitive to the changes in variables, the firm can explore the variability of that critical factor.

This method is very subjective in nature and suffers from certain limitations. Sensitivity analysis shows the change in NPV due to the change in variables and does not talk about how likely the change will be. Also, under this method, it is assumed that one variable changes at a time, but in reality, variables tend to move together.

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