SENSITIVITY ANALYSIS:
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SENSITIVITY ANALYSIS:
Ø NPV of the project are calculated out of estimates of cash flow that are invariably derived from forecasts of other primary variables, such as the project’s life, salvage value, production costs etc.
Ø Sensitivity analysis is the process where impact of each variable upon NPV is studied, only one at a time, keeping the other variable as constant.
Ø Sensy.Anly. is useful in identifying the crucial variable that could contribute the most to the riskiness of the investments
Ø Sensitivity Analysis enables managers to assess how responsive the NPV is to changes in the variables which are used to calculate it.
Steps: Sensitivity Analysis involves three steps
(i) Identification of all those variables having an influence on the project’s NPV or IRR.
(ii) Definition of the underlying quantitative relationship among the variables.
(iii) Analysis of the impact of the changes in each of the variables on the NPV of the project.
Sensitivity Analysis answers questions like,
(i) What happens to the present value (or some other criterion of merit) if flows are, say Rs. 50,000 than the expected Rs.80,000?
(ii) What will happen to NPV if the economic life of the project is only 3 years rather than expected 5 years?
Importance: It directs the management to pay maximum attention towards the factor where minimum percentage of adverse change causes maximum adverse effect.
Only a tool: However, it should not be viewed as the method to remove the risk or uncertainty, it is only a tool to analyze and Measure the risk and uncertainty.
Assumptions: In terms of capital budgeting the possible cash flows are based on three assumptions:
(a) Cash flows may be worst (pessimistic)
(b) Cash flows may be most likely
(c) Cash flows may be most optimistic.
Computation: Sensitivity of a variable is calculated by using following relation: Sensitivity (%) = Change/Base x 100
Decision: If NPV were to become 0 with 2% change in fixed costs relative to 10% change in sales, project is said to be more sensitive to fixed costs than to sales. This is because a small change in fixed costs leads to a reversal of investment decision.
Limitations:
(i) Sensitivity Analysis assumes variables to be completely unrelated / independent to each other, which is generally not the case.
(ii) There is no clear roadmap to indicate how the decision-maker will use results of the sensitivity analysis.
In Sensitivity Analysis Finance Manager seeks answer to “What if” Situations.
Some parameters to be used under Sensitivity Analysis are Size of the project, Cash flows, Life of the project, Discount Rate.
Under this analysis each input variable (parameters) is considered separately and all other variables are held constant.
Hence wherever there is an uncertainty, of whatever type, the sensitivity analysis plays a crucial role.
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