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.
Advantages of Financial Sensitivity Analysis
- Sensitivity analysis adds credibility to any type of financial model by testing the model across a wide set of possibilities.
- Financial Sensitivity Analysis allows the analyst to be flexible with the boundaries within which to test the sensitivity of the dependent variables to the independent variables. For example, the model to study the effect of a 5-point change in interest rates on bond prices would be different from the financial model that would be used to study the effect of a 20-point change in interest rates on bond prices.
- Sensitivity analysis helps one make informed choices. Decision-makers use the model to understand how responsive the output is to changes in certain variables. Thus, the analyst can be helpful in deriving tangible conclusions and be instrumental in making optimal decisions.
In the direct method, you would substitute different numbers into an assumption in a model. Using the direct method, we substitute different numbers to replace the growth rate to see the resulting revenue amounts.
For example, if your revenue growth assumption is 15% year over year, the revenue formula is:
(Last year’s revenue) x (1 + 15%)
In the indirect method, you insert a percent change into formulas instead of directly changing the value of an assumption. For example, if your revenue growth assumption is 10% year over year and we know that the revenue formula is:
(Last year’s revenue) x (1 + 10%)
- Firstly, the analyst is required to design the basic formula, which will act as the output formula. For instance, say NPV formula can be taken as the output formula.
- Next, the analyst needs to identify which are the variables that are required to be sensitized as they are key to the output formula. In the NPV formula in excel, the cost of capital and the initial investment can be the independent variables.
- Next, determine the probable range of the independent variables.
- Next, open an excel sheet and then put the range of one of the independent variable along the rows and the other set along with the columns.
- Range of 1st independent variable
- Range of 2nd independent variable