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Syllabus G. Finance In Planning And Decision-Making G2. Adjusting For Risk And Uncertainty In Investment Appraisal

G2d. Sensitivity Analysis

How sensitive is the project to ONE particular variable

It basically shows as a % how much ONE variable has to change before the NPV becomes zero

The smaller the % change needed the more focus managers should give the item generally

The Calculation

  • The smaller the percentage, the more sensitive the decision is to a change in the variable

Illustration

ACCA colleges are considering a project which will cost them an initial 10,000

The cashflows expected for the 2 year duration are 10,000pa. 

The variable costs are 1,000pa

Cost of capital 10%

Calculate the sensitivity analysis of all variables

  • Solution

    PV of project as a whole:

Year 0 1 2
Investment (10,000)    
Costs   (1,000) (1,000)
Sales   10,000 10,000
Discount Factor 1 0.909 0.826
Discounted Cashflows (10,000) 8,181 7,434

So the NPV as a whole is 5,615

Sensitivity of Initial Investment
5,615 / 10,000 = 56%

Sensitivity of Costs
5,615 / (909 + 826) = 323%

Sensitivity of Sales
5,615 / (9,090 + 8,260) = 32%

Weakness of Sensitivity Analysis

  • Each variable must change in isolation

    Yet they are often interdependent upon each other

  • It does not take into account probabilities of change occurring

  • Some factors management may not control