Sensitivity analysis (SA) :
In the context of an NPV appraisal, SA involves six steps:
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Identify and estimate the various input factors to the decision.
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Assess the project on the basis of the best estimates.
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Take each input factor in turn and determine the value for it that will give a zero NPV for the project when the other factors are left at their original estimated values.
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Compare each of the values determined in step 3 with the original best estimate to gain an impression of the riskiness of the factor under consideration.
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Carry out any necessary research (for example, market research) to reassess the risk in sensitive areas.
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Make the decision and take any appropriate actions to reduce the risk in sensitive areas (for example, entering fixed-price contracts for raw material purchases).
Benefits of SA:
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Enables the decision maker to ‘get inside’ the project and see what are the key issues.
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Easy to carry out and understand.
Problems with SA:
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No decision rule provided.
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Sensitivities are not directly comparable from one input factor to the next.
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Rather static approach; ‘scenario building’ might be better.
