How do you validate and test the accuracy and reliability of IRR and sensitivity analysis?

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IRR and sensitivity analysis are common tools for evaluating the feasibility and profitability of a project or investment. However, they are not foolproof and can be affected by various assumptions, inputs, and errors. How do you validate and test the accuracy and reliability of these methods? Here are some tips and best practices to follow.

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Jigar Shah

?? Partner at Advised Arms LLP | Xero Advisor Certified ? | Top Voice ?? | Expertise: Business Development, Management…

1 Understand the assumptions

The first step is to understand the underlying assumptions that go into calculating the IRR and sensitivity analysis. These may include the discount rate, the cash flow projections, the growth rate, the terminal value, the risk factors, and the scenario analysis. You should check the validity, consistency, and reasonableness of these assumptions, and compare them with historical data, industry benchmarks, and market conditions. You should also document and justify your assumptions, and explain how they affect the results.

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Jigar Shah

?? Partner at Advised Arms LLP | Xero Advisor Certified ? | Top Voice ?? | Expertise: Business Development, Management Accounting, Teamwork, Brand Strategy, Cost Accounting, Account Management
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?? Start by thoroughly understanding the assumptions underlying your IRR and sensitivity analysis. These might include projected cash flows, discount rates, and growth rates. Scrutinize each assumption for realism and relevance. Ensure they are based on reliable data and realistic expectations. Any flawed assumption can lead to incorrect conclusions.

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2 Perform sensitivity analysis

The second step is to perform sensitivity analysis, which is a technique that measures how the IRR and other outcomes change when one or more variables are changed. This can help you identify the key drivers of value, the potential risks and opportunities, and the break-even points of your project or investment. You should vary the variables within a realistic range, and use both optimistic and pessimistic scenarios. You should also analyze the impact of each variable individually and in combination, and present the results in a clear and visual way, such as using tables, graphs, or charts.

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Jigar Shah

?? Partner at Advised Arms LLP | Xero Advisor Certified ? | Top Voice ?? | Expertise: Business Development, Management Accounting, Teamwork, Brand Strategy, Cost Accounting, Account Management
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?? Conduct sensitivity analysis to see how changes in key assumptions impact the IRR. Vary parameters such as sales volume, cost of goods sold, or discount rates to observe how sensitive the IRR is to these changes. This helps in identifying the most critical factors that affect your project's viability and prepares you for different scenarios.

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3 Check for errors and anomalies

The third step is to check for errors and anomalies in your calculations and data. You should use a reliable and consistent spreadsheet or software, and apply quality control and verification methods, such as cross-checking, auditing, and testing. You should also look for any outliers, discrepancies, or illogical results that may indicate a mistake or a flaw in your model or assumptions. For example, you should check if your IRR is higher than your discount rate, if your cash flows are negative or inconsistent, or if your sensitivity analysis shows extreme or contradictory outcomes.

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Jigar Shah

?? Partner at Advised Arms LLP | Xero Advisor Certified ? | Top Voice ?? | Expertise: Business Development, Management Accounting, Teamwork, Brand Strategy, Cost Accounting, Account Management
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?? Meticulously review your calculations to spot any errors or anomalies. Use error-checking tools in your financial software or spreadsheets to identify inconsistencies. Cross-verify figures and ensure that formulas are correctly applied. Anomalies often indicate errors or unrealistic assumptions that need to be addressed.

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4 Compare with alternative methods

The fourth step is to compare your IRR and sensitivity analysis with alternative methods of evaluating your project or investment. These may include the net present value (NPV), the payback period, the return on investment (ROI), the profitability index, or the cost-benefit analysis. You should understand the advantages and disadvantages of each method, and how they relate to your objectives, criteria, and preferences. You should also explain why you chose the IRR and sensitivity analysis as your primary methods, and how they support your decision making.

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5 Seek feedback and validation

The final step is to seek feedback and validation from other sources and stakeholders. You should present your IRR and sensitivity analysis in a clear, concise, and persuasive way, and highlight the main findings, implications, and recommendations. You should also invite questions, comments, and suggestions from your audience, and address any concerns or objections they may have. You should also consider using external data, experts, or benchmarks to validate and corroborate your results, and to enhance your credibility and confidence.

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6 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?

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How do you validate and test the accuracy and reliability of IRR and sensitivity analysis?

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1 Understand the assumptions

2 Perform sensitivity analysis

3 Check for errors and anomalies

4 Compare with alternative methods

5 Seek feedback and validation

6 Here’s what else to consider

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