What is the impact of sensitivity analysis on capital budgeting projections?

2 How does sensitivity analysis work?

To perform sensitivity analysis, you need to identify the key variables that affect your project's cash flows and the range of possible values for each variable. Then, you need to calculate your project's NPV or IRR for each value of each variable, while keeping the other variables at their base case or expected values. You can use a spreadsheet or a software tool to create a table or a graph that shows the relationship between each variable and your project's NPV or IRR. This will help you visualize how your project's performance varies with different scenarios.

3 Why is sensitivity analysis important?

Sensitivity analysis is important because it helps you understand the risks and uncertainties involved in your capital budgeting project. It shows you which variables have the most impact on your project's profitability and how much cushion you have before your project becomes unprofitable. It also helps you evaluate the trade-offs between different alternatives and choose the one that maximizes your return while minimizing your risk. Sensitivity analysis can also help you communicate your assumptions and expectations to your stakeholders and justify your decisions.

4 What are the limitations of sensitivity analysis?

Sensitivity analysis has some limitations that you need to be aware of. First, it assumes that only one variable changes at a time, while in reality, multiple variables may change simultaneously and interact with each other. Second, it does not account for the probability or likelihood of each scenario, which may affect your decision-making. Third, it does not consider the impact of external factors, such as market conditions, competition, regulation, etc., that may affect your project's cash flows. Fourth, it may be difficult to determine the appropriate range of values for each variable, especially if you have limited data or experience.

5 What are the challenges of using sensitivity analysis?

Using sensitivity analysis can also pose some challenges that you need to overcome. One challenge is to select the relevant variables and the appropriate level of detail for your analysis. You need to balance between simplicity and complexity, and avoid including too many or too few variables. Another challenge is to interpret the results of your analysis and use them to make informed decisions. You need to avoid being overconfident or overly pessimistic, and consider the trade-offs and uncertainties involved. A third challenge is to update your analysis as new information becomes available and as your project progresses. You need to monitor your project's performance and adjust your assumptions and expectations accordingly.

Sensitivity analysis is a useful technique that can help you improve your capital budgeting projections and decisions. By applying sensitivity analysis, you can assess how different factors affect your project's profitability and risk, and choose the best alternative for your situation. However, you also need to be aware of the limitations and challenges of using sensitivity analysis, and use it with caution and judgment.