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How can sensitivity analysis help you evaluate changes in interest rates?

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Interest rates are one of the most important factors that affect the value of financial assets and liabilities. Changes in interest rates can have a significant impact on the cash flows, profitability, and risk of a business. Therefore, it is crucial for corporate finance managers to understand how sensitive their financial decisions are to different interest rate scenarios. This is where sensitivity analysis comes in handy.

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1 What is sensitivity analysis?

Sensitivity analysis is a technique that helps you measure how the outcome of a financial model or a project changes when you vary one or more input variables. For example, you can use sensitivity analysis to see how the net present value (NPV) of an investment changes when you change the discount rate, the growth rate, or the initial cost. Sensitivity analysis can help you identify the key drivers of value, the range of possible outcomes, and the degree of uncertainty in your assumptions.

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2 How to perform sensitivity analysis?

Sensitivity analysis can be done using several methods, the most popular being one-way sensitivity analysis. This involves varying one input variable and evaluating the result on the output variable. An example of this is creating a table or chart to show the change in NPV of a project when the discount rate is adjusted from 5% to 15%. Two-way sensitivity analysis is another method that involves changing two input variables at a time and observing the effect on the output variable. A matrix or contour plot can be used to show how the NPV changes when both the discount rate and growth rate are varied. Scenario analysis is a third method which involves changing multiple input variables and creating different scenarios that reflect different assumptions or events. For instance, a base case, best case, and worst case scenario for a project can be created to compare their respective NPVs.

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3 Why use sensitivity analysis for interest rates?

Sensitivity analysis for interest rates can help you evaluate how your financial decisions are affected by changes in the cost of borrowing or lending, the market value of your assets or liabilities, and the expectations of future cash flows. This analysis offers several benefits, such as assessing the risk and return trade-off of different financing options, evaluating the profitability and feasibility of investment opportunities, and managing your exposure to interest rate risk. Specifically, you can see how the interest rate affects your cost of capital, leverage ratio, earnings per share, cash flow projections, payback period, internal rate of return, duration, convexity, immunization of a bond portfolio, delta, gamma, and theta of interest rate derivatives.

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Jose Bueno

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The sensitivity analysis is carried out within the company in order to facilitate decision making, which will indicate the variables that most affect the economic result of a project and which are the variables that have little impact on the final result. When doing any analysis projected into the future, there is always an element of uncertainty associated with the alternatives and it is precisely this lack of certainty that makes decision difficult. In an individual project, the sensitivity should be made with respect to the most uncertain parameter; For example, if there is uncertainty regarding the sales price of the item that is planned to be manufactured, it is important to determine how sensitive the Internal Rate of Return (IRR).

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4 How to interpret sensitivity analysis results?

Sensitivity analysis results can provide valuable insights and information to help you make informed and robust financial decisions. However, you need to be careful and critical when interpreting the results, as they are based on assumptions and estimates that may not be accurate or realistic. When interpreting sensitivity analysis results, focus on the most relevant and material input variables that have the largest impact on the output variable, while using a range of plausible values to reflect the uncertainty and variability of the market conditions and business environment. Additionally, it is important to compare the results across different scenarios and methods to check the consistency and sensitivity of your analysis.

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Matthew Hochman

Senior Consultant at Apkudo | FP&A Professional | Financial Modeling | Project Management | Commercial Sales Finance | GTM Finance | Corporate Finance | High Growth Start Up/SAAS
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For example, if a sensitivity analysis is applied to determine under different revenue changes, how will total expense reach as revenue grows? Its helpful to show during both a downturn and upturn in the economy, what will the cost impact be from a P&L standpoint and at what point will I need to find alternative sources of either revenue or cost cutting measures to keep on track to hit my cost targets for the fiscal year.

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5 How to present sensitivity analysis results?

Presenting sensitivity analysis results can take on various forms, depending on the purpose and audience of the analysis. Common ways of presenting sensitivity analysis results include tables, charts, and dashboards. Tables are useful for displaying precise and detailed information, but can be difficult to read for large or complex data sets. Charts can show the graphical relationship between the output variable and the input variables; however, they may be misleading or confusing for non-linear or multi-dimensional data sets. Dashboards are useful for displaying high-level and concise information, but may not provide enough depth or context for your analysis.

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Matthew Hochman

Senior Consultant at Apkudo | FP&A Professional | Financial Modeling | Project Management | Commercial Sales Finance | GTM Finance | Corporate Finance | High Growth Start Up/SAAS
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Its always helpful to understand your audience; that way, you can present the sensitivity analysis results tailored to the stakeholders (whether finance or non finance stakeholders) so that they can understand the results in a clear, concise manner. When presenting the results, I have found that presenting the results through dashboards via BI tools such as Tableau or Adaptive can help paint an overall picture with reinforcing data points and/or metrics overlaid into one single page of visualizations.

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Noura Zein

Finance Business Partner| Corporate Finance | Investment & Strategy | Drive finance & Business performance into competitive advantages through vision and leadership
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When presenting sensitivity analysis results, start with an introduction, show the base case, display scenarios, highlight key findings, provide actionable insights, use visuals, and conclude with a summary. Keep it clear and concise! ????

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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 can sensitivity analysis help you evaluate changes in interest rates?

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1 What is sensitivity analysis?

2 How to perform sensitivity analysis?

3 Why use sensitivity analysis for interest rates?

4 How to interpret sensitivity analysis results?

5 How to present sensitivity analysis results?

6 Here’s what else to consider

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