What is Sensitivity Analysis? Pros and Cons

sensitivity analysis

What is Sensitivity Analysis?

Sensitivity Analysis is a way of analyzing change in the NPV of the project for a given change in one of the variables.

It indicates how sensitive a project’s NPV or IRR is to changes in particular variables. The more sensitive the NPV, the more critical is the variable. Following steps are involved in doing the sensitivity analysis of any project –

  1. Identification of all those variables, which have an influence on project’s NPV and IRR.
  2. Defining the underlying relationship between the variable.
  3. Analyzing the impact of the change in each of the variables on the project’s NPV.

While performing sensitivity analysis, decision maker computes project’s NPV or IRR for each forecast under three assumptions –

  • Pessimistic
  • Expected
  • Optimistic

These three assumptions help the decision maker to answer the questions starting from ‘what if’. For example, What if volume increases or decreases? What if  the selling price increases or decreases? What if variable cost or fixed costs increases or decreases?

One can answer a whole range of questions with the help of sensitivity analysis. It examines the sensitivity of the variables underlying the computation of NPV or IRR. However, it does not do any attempt to quantify the risk. It is applicable to any variable which is an input for after tax cash flows.

Sensitivity Analysis and Break Even Analysis

It is a variation of the break even analysis. In sensitivity analysis, you ask what shall be the consequences if volume or price or cost changes? You can ask this question slightly differently. How much lower can the sales volume become before the project becomes unprofitable? In reality, what you are asking is the break-even point.

The most important thing to note is that, DCF break-even point is different from the accounting break – even point. The accounting break- even point is the ratio of fixed cost to contribution ratio. It does not takes into consideration opportunity cost of capital. In addition to this, here fixed cost comprises of both cash plus non cash costs. It is possible that you may be operating above break-even point in accounting however still losing money because of ignorance of opportunity cost of capital.

Pros of Sensitivity Analysis

  • It compels decision maker to identify the variables that affects the cash flow forecasts. This helps in a clear understanding of the investment project.
  • Indicates critical variables which may require additional information.
  • Helps in exposing inappropriate forecasts and guides the decision makers to focus on relevant variables.

Cons of Sensitivity Analysis

  • It does not provide accurate results. The words optimistic and pessimistic can mean different things to different persons in a company.
  • It does not explains the interrelationship between the variables.
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