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Greetings Tutor. I hope you are doing well.
Can you please help me with the following.VYXYN Co. (March/June 2017).
Req C- Asks for “Critically discuss how risk can be considered in the investment appraisal process”.The suggested answer included Sensitivity Analysis as one of the ways of considering risk in the investment appraisal.
But Sensitivity Analysis does not really consider risk as although a variable might be identified as a critical success factor but in reality the chances of such variable changing might be very less.Even the suggested answer mentions “However, as
sensitivity analysis does not consider risk as measured by probabilities, it can be argued
that it is not really a way of considering risk in investment appraisal at all, even though it is often described as such.”So should we really even mention Sensitivity Analysis as a way of considering risk in the investment appraisal process.
Adding a bit more to it.
DYSXA Co (Dec 2016)
Req (d) “Discuss 2 ways in which the risk of a project can be assessed?”
Examiner’s Comment on this requirement states “The most common error was to discuss sensitivity analysis as a way in which risk can be assessed. This is not the case. Sensitivity analysis is a method of analysing the uncertainty surrounding a project”.Hi!
Well sensitivity analysis helps identify critical variables and their impact on project outcomes, it does not measure the probability of changes in those variables. Therefore, it primarily addresses uncertainty rather than risk, which involves quantifiable probabilities of different outcomes.
In the context of your question, it is valid to mention sensitivity analysis as a method of analysing uncertainty, but it may not be appropriate to classify it strictly as a way to assess risk.
The examiner’s comments you referenced highlight this distinction, indicating that sensitivity analysis is more about understanding the potential variability in project outcomes rather than assessing the likelihood of those outcomes occurring.
Thus while sensitivity analysis can be discussed in the context of investment appraisal, it should be framed as a tool for analysing uncertainty rather than a direct method for assessing risk.Thankyou Tutor.
May I know how Sensitivity Analysis addresses uncertainty ?Sensitivity analysis is a technique that helps assess the uncertainty of a project’s Net Present Value (NPV) by testing how the NPV changes when variables are changed.
You can repeat this process for different variables and changes, and see the results to ascertain which variables have the most impact on the NPV.
So, by changing one variable at at time to get say break even NPV you can see which variable is the most sensitive to changes.
Thankyou Tutor.
But I’m still having difficulty fully understanding this concept.
Could you kindly explain it to me again?How change in NPV because of change in one variable will help me to assess uncertainty.
In simple terms:
NPV as a whole is 6000NPV / PV of the uncertain cflow * 100
Sensitivity of Initial Investment
6000/ 10,000 = 60%Sensitivity of Costs
PV of costs = 17350
6000/ 17350 = 35%Sensitivity of Sales
PV of costs = 28000
6000/ 28,000= 21%This tells you the most sensitive is sales
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