Sensitivity analysis

Yes, that’s what I thought so (your statement)

But the answer given in JUNE 2015 Q5(b) HRAXIN CO is this below:

Sensitivity analysis assesses the extent to which the net present value (NPV) of an investment project responds to changes in project variables.

Two methods are commonly used: one method determines the percentage change in a project variable which results in a negative NPV, while the other method determines the percentage change in NPV which results from a fixed percentage change (for example, 5%) in each project variable in turn.

Whichever method is used, the key or critical project variables are identified as those to which the NPV is most sensitive, for example, those where the smallest percentage change results in a negative NPV. Sensitivity analysis is therefore concerned with calculating relative changes in project variables.

When discussing risk in the context of investment appraisal, it is important to note that, unlike uncertainty, risk can be quantified and measured.

The probabilities of the occurrence of particular future outcomes can be assessed, for example, and used to evaluate the volatility of future cash flows, for example, by calculating their standard deviation.

The probabilities of the future economic states in the assessment of the investment project of Hraxin Co are an example of probability analysis and these probabilities can lead to an assessment of project risk.

Sensitivity analysis is usually studied in investment appraisal in relation to understanding how risk can be incorporated in the investment appraisal process.

While sensitivity analysis can indicate the critical variables of an investment project, however, sensitivity analysis does not give any indication of the probability of a change in any critical variable.

Selling price may be a critical variable, for example, but sensitivity analysis is not able to say whether a change in selling price is likely to occur.

In the appraisal of the investment project of Hraxin Co, the probabilities of different selling prices arising with related economic states have come from probability analysis, not from sensitivity analysis.

Sensitivity analysis will not therefore directly assist Hraxin Co in assessing the risk of the investment project.

However, it does provide useful information which helps management to gain a deeper understanding of the investment project and which focuses management attention on aspects of the investment project where problems may arise.

Thanks