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Chapter 9

2.3 Sensitivity analysis

Sensitivity analysis measures the change in a particular variable which
can be tolerated before the NPV of a project reduces to zero.

Sensitivity = (NPV of project)/(PV of cash flows affected by the
estimate) × 100%

Example 3

For example, AVI Co is appraising a new project, buying a machine today for
$600,000 that is expected to generate revenue of $1 million per year for 4
years. Associated costs are $600,000 per year and the tax rate is 30%.

The project’s NPV (at a discount rate of 10%) has been calculated as
$430,000.

Sensitivity to changes in the selling price would be:

= (NPV/PV of cash flows affected by the estimate of selling price) × 100%

= [430,000/(1,000,000 × (1 – 0.30) × 3.170)] × 100%

= 19.4%

i.e. if sales were to fall by 19.4% (to $806,000 per year) then the NPV would
be zero.

Sensitivity analysis only allows us to assess the impact of one variable
changing at a time. Simulation addresses this problem by considering
how the NPV will be impacted by a number of variables changing at
once.

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