How do you calculate expected value using sensitivity analysis?

1 What is sensitivity analysis?

Sensitivity analysis is a method of changing one or more variables in a model and observing how the results change. For example, you can change the discount rate, the sales growth rate, or the cost of capital in a cash flow projection and see how the net present value (NPV) or the internal rate of return (IRR) change. Sensitivity analysis can help you identify the most critical variables, the range of possible outcomes, and the level of risk and uncertainty in your decision.

2 What is expected value?

Expected value is a statistical concept that measures the average outcome of a random event. It is calculated by multiplying each possible outcome by its probability and then summing them up. For example, if you toss a fair coin, the expected value of the number of heads is 0.5 x 1 + 0.5 x 0 = 0.5. Expected value can be used to evaluate the profitability or feasibility of a project or a decision by estimating the average cash flow over time.

3 How to use sensitivity analysis to calculate expected value?

To use sensitivity analysis to calculate expected value, you need to first define the base case scenario, which is the most likely or realistic set of assumptions for your model. This can be done by utilizing historical data, market research, or industry benchmarks. Additionally, you should define alternative scenarios that are variations of the base case scenario with different values for one or more variables. These can include the best case and worst case scenarios, as well as other scenarios that reflect different levels of optimism or pessimism. After assigning probabilities to each scenario, which reflect your subjective judgment or objective data about how likely each scenario is to occur, you can calculate the expected value of the cash flow for each period by multiplying the cash flow of each scenario by its probability and then summing them up. Lastly, calculate the expected value of the project by discounting the expected value of the cash flow for each period by the appropriate discount rate and then summing them up.

4 What are the benefits and limitations of sensitivity analysis?

Sensitivity analysis can help you understand the impact of different variables on your decision, compare different scenarios, and assess the risk and uncertainty of your project. It can also be used to communicate assumptions and results to others, such as investors, managers, or clients. However, sensitivity analysis has some limitations. It does not consider interactions or correlations between variables, which could affect the outcome in a nonlinear or complex way. Additionally, it relies on subjective probabilities, which may be biased or inaccurate. Furthermore, it may not capture all the possible scenarios or outcomes, which may be more extreme than what you initially considered.

5 How to improve your sensitivity analysis skills?

Sensitivity analysis is a useful and versatile tool for accounting and capital budgeting, but it requires practice and experience to apply it effectively. To improve your skills, consider using a spreadsheet or a software program to create and modify your model, as this can save time and reduce errors. It's also wise to use a range of values for each variable, rather than a single point estimate, as this can reflect the uncertainty and variability of the real world. Additionally, you should use a sensitivity table or chart to display and visualize your results, as this can help you identify the key drivers and the trade-offs of your decision. Complementing your sensitivity analysis with a scenario analysis or simulation analysis can provide more information and insights about the distribution and likelihood of outcomes. Lastly, review and update your model regularly, as the assumptions and data may change over time.

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?