What are the best practices for conducting a sensitivity analysis in capital budgeting?

1 Choose relevant variables

The first step in conducting a sensitivity analysis is to select the variables that have the most impact on the cash flows and the profitability of a project. These variables can be related to the project itself, such as the initial investment, the operating costs, the sales volume, or the price, or to the external environment, such as the interest rate, the inflation rate, the exchange rate, or the tax rate. You should choose variables that are uncertain, variable, and controllable, and that reflect the specific characteristics and risks of the project.

2 Define scenarios and ranges

The next step is to define different scenarios and ranges for each variable. A scenario is a set of assumptions that represent a possible outcome of a project. For example, you can define a base case scenario that reflects the most likely values of the variables, a best case scenario that reflects the most optimistic values, and a worst case scenario that reflects the most pessimistic values. A range is the difference between the highest and the lowest value of a variable. For example, you can define a range of 10% to 20% for the sales growth rate of a project. You should use realistic and consistent scenarios and ranges that are based on historical data, market research, or expert opinions.

3 Calculate NPV or IRR for each scenario

The third step is to calculate the NPV or the IRR of the project for each scenario. The NPV is the difference between the present value of the cash inflows and the present value of the cash outflows of a project. The IRR is the discount rate that makes the NPV of a project equal to zero. Both measures indicate the profitability and the viability of a project. You should use a spreadsheet or a software tool to create a financial model that calculates the NPV or the IRR of the project based on the values of the variables in each scenario.

4 Analyze the results and draw conclusions

The final step is to analyze the results and draw conclusions from the sensitivity analysis. You can present and interpret the results using various methods, such as tables, charts, graphs, or dashboards. Sensitivity tables show how the NPV or the IRR of a project changes as one or two variables change across different values. Spider charts display how sensitive the NPV or the IRR of a project is to changes in each variable, while tornado charts illustrate how much each variable contributes to the variability of the NPV or the IRR of a project. Break-even charts demonstrate the values of the variables that make the NPV or the IRR of a project equal to zero. Ultimately, you should use these results to evaluate the feasibility, profitability, and riskiness of a project, as well as support your decision making and plan for contingencies and alternatives.

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?