Investment Appraisal - Sensitivity Analysis

Sensitivity analysis is a technique which allows the analysis of changes in assumptions used in forecasts. As such, it is a very useful technique for use in investment appraisal.

Assumptions Used in Business Forecasting

There are many examples of where assumptions need to be made by management as they prepare important business forecasts: for example:

Cash-flow forecast

• Timing of cash inflows and outflows
• Amount of cash inflows and outflows
• Receivables & payables days

Budgeted Profit

• Sales volumes and unit selling prices
• Gross profit margins & overheads

Investment Appraisal

• Timing and amount of project cash flows
• Period over which project will run
• Amount of initial investment

Breakeven Analysis

• Average selling prices and variable costs
• Fixed costs by category and total

The key questions to ask whenever you are looking at business assumptions like those listed above are:

• How reliable are the assumptions made?
• What happens if assumptions turn out to be significantly different in reality?
• Which assumptions are most significant to the forecast?

Sensitivity analysis helps answer these questions!

Key Points About Sensitivity Analysis

Allows key assumptions to be changed to analyse effect

Helps judge the degree of risk (e.g. in an investment project)

Recognises that there is no such thing as an accurate forecast

Considers one variable or assumption at a time

Benefits and Drawbacks of Sensitivity Analysis

Benefits:

Identifies the most significant assumptions (which therefore require closer attention)

Helps assess risk and prepare for a less-than-favourable scenario

Helps make the process of business forecasting more robust

Drawbacks:

Only tests one assumption at a time (many assumptions may be linked)

Only as good as the data on which forecasts are based

A somewhat complicated concept – not understood by all managers