May 20, 2020

Sensitivity analysis is a finance management term. It enables managers to assess how responsive the Net Present Value is to changes in the variables which are used to calculate it.

Sensitivity analysis answers questions like:

• What happens to the Net Present Value if inflows are, say Rs. 40,000 than the expected Rs.60,000?
• What will happen to NPV if the economic life of the project is only 2 years rather than the expected 5 years?

The importance of sensitivity analysis is it directs the management’s focus towards the factors where the minimum percentage of adverse change causes the maximum adverse effect.

Sensitivity of a variable is calculated by using the following relation :

Sensitivity (%) = (Change / Base) x100

Merits of sensitivity analysis are:

1. It forces management to identify underlying variables and their inter-relationship.
2. Shows how robust or vulnerable a project is to change in underlying variables.

One of the demerit of sensitivity analysis is that the study of the impact of variation in one factor at a time while holding other factors constant. This may not be very meaningful when underlying factors are likely to be inter-related.

How to compute sensitivity analysis?

NPV = C.F. x PVIFA (Kc,n) – I

where, NPV = Net Present Value. C.F. = Cash Inflows. Kc = Cost of capital. I = Investment.

While performing sensitivity analysis of a factor we keep NPV = 0.

This means that whatever will be our MOS (Margin of Safety) or sensitivity (%), it will always keep the project’s NPV at 0. In case if we increase the sensitivity %, our NPV will start getting negative.

Let us understand the above concept by solving a practical problem.