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# DEFINITION of 'Sensitivity Analysis' NPW to both changes in key variables and to the range of likely

A technique used to determine how different values of an independent variable values. The decision maker may consider two extreme cases,
variable will impact a particular dependent variable under a given set a
of assumptions. This technique is used within specific boundaries that worst-case scenario (low unit sales, high variable cost
will depend on one or more input variables, such as the effect that per unit, high fixed cost, and so on) and a
changes in interest rates will have on a bond's price.
Best-case scenario to identify the extreme and most
Sensitivity Analysis (SA): Determines the effect on the PW of likely project outcomes.
variations in the input variables (revenues, operating cost, and salvage
value). SA is sometimes called what if analysis because it answers
questions such as, Scenario analysis commonly focuses on estimating what a portfolio's
What if incremental sales are only 1,000 units, rather than 2,00 units? value would decrease to if an unfavorable event, or the "worst-case
Then scenario", were realized. Scenario analysis involves computing
different reinvestment rates for expected returns that are reinvested
What will be the NPW be?
during the investment horizon.
SA begins with a base-case situation, which is developed using
most-likely values for each input. A useful way to present results There are many different ways to approach scenario analysis, but a
of sensitivity analysis is to plot sensitivity graphs. common method is to determine what the standard deviation of daily
Sensitivity analysis is a way to predict the outcome of a decision if a or monthly security returns are, and then compute what value would
situation turns out to be different compared to the key prediction(s). be expected for the portfolio if each security generated returns two or
three standard deviations above and below the average return.
Sensitivity analysis is very useful when attempting to determine the
impact the actual outcome of a particular variable will have if it differs
In this way, an analyst can have reasonable certainty that the value of
from what was previously assumed. By creating a given set of
a portfolio is unlikely to fall below (or rise above) a specific value
scenarios, the analyst can determine how changes in one variable(s)
during a given time period.
will impact the target variable.
For example, an analyst might create a financial model that will value a Sensitivity analysis can be a useful tool in dealing with risk. It typically
company's equity (the dependent variable) given the amount of shows how sensitive the overall result (NPV) is to a change to a key
earnings per share (an independent variable) the company reports at variable (such as key costs and benefits that involve risk/uncertainty
the end of the year and the company's price-to-earnings multiple and the discount rate). However, sensitivity analysis is only useful to
(another independent variable) at that time. The analyst can create a the extent it looks at likely occurrences, rather than extreme ones in
table of predicted price-to-earnings multiples and a corresponding this way it should be linked to the probability that the outcome being
value of the company's equity based on different values for each of the sensitivity tested is likely to occur.
independent variables.
A scenario analysis consists of multiple sensitivity tests that are
performed simultaneously. It evaluates the changes to outcomes as a
DEFINITION of 'Scenario Analysis'
result of changes to multiple variables under different likely scenarios.
The changes to the variables in a scenario analysis should be realistic
The process of estimating the expected value of a portfolio after a
and be based on optimistic and pessimistic scenarios that have a
given period of time, assuming specific changes in the values of the
reasonable likelihood of occurring, rather than extreme cases.
portfolio's securities or key factors that would affect security values,
such as changes in the interest rate.
Scenario Analysis is a technique that does consider the sensitivity of
The results generated from the sensitivity or scenario analysis should correlated or interrelated with another variable. For example, the
be clearly presented so the impact of risk and uncertainty on the quantity of goods is interrelated to the price and cost of the good. A
results of the economic evaluation are known to decision-makers. change in one impact would indirectly change another and the overall
Special care is needed when testing for the impact of a change in a key result. When there are significant interactions between variables, and
variable on the change in net benefits since a variable can be where the expected impacts of the proposal justify additional complex
analysis, a Monte Carlo simulation could provide more robust results.