How can you use sensitivity analysis to evaluate capital project risks?

1 What is sensitivity analysis?

Sensitivity analysis is a technique that measures how the outcome of a decision or a model changes when one or more input variables are altered. It helps to identify the key drivers of the outcome, the range of possible outcomes, and the sources of risk and uncertainty. For example, if you want to evaluate the profitability of a new product, you can use sensitivity analysis to see how the net present value (NPV) of the project changes when you vary the sales volume, the price, the cost, the discount rate, or other factors.

2 How does sensitivity analysis work?

Conducting sensitivity analysis involves several steps, such as defining the base case scenario and identifying the relevant variables that can affect the outcome. Calculating the outcome requires a formula, spreadsheet, simulation, or other tool. Comparing and analyzing the results can be done with visual aids like graphs, charts, or tables; calculating the sensitivity index is also an option. Finally, it's important to interpret and communicate the findings, highlighting any implications for the decision or model.

3 Why is sensitivity analysis important?

Sensitivity analysis is important for several reasons, including testing the robustness and validity of a decision or model, identifying and quantifying the risks and uncertainties of the decision or model, optimizing and improving the decision or model, as well as communicating and justifying the decision or model. Specifically, sensitivity analysis can show how sensitive a decision or model is to changes in input variables, the range and probability of possible outcomes, how to adjust input variables to achieve the desired outcome, and the assumptions, scenarios, and trade-offs involved.

4 How to apply sensitivity analysis to capital projects?

Sensitivity analysis is a tool used to evaluate capital project risks, but it also has some limitations. This method changes one or multiple input variables at a time, based on predefined scenarios or probability distributions, and shows how the outcome changes. One-way sensitivity analysis is simple and easy to perform, while scenario analysis and Monte Carlo simulation are more comprehensive but require more data and assumptions. However, sensitivity analysis may not account for all relevant variables and uncertainties, it may rely on subjective data and assumptions, and it may not provide a clear answer or recommendation. Therefore, it should be used with caution and judgment, and be complemented with other methods for capital budgeting.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?