SENSITIVITY ANALYSIS

Summary

Sensitivity analysis is a risk assessment technique that examines how changes in key variables or assumptions affect the outcome of a financial model or decision. Think of it as a 'what-if' analysis that helps decision-makers understand which inputs have the most impact on results like Net Present Value (NPV), and how sensitive their conclusions are to changes in uncertain parameters. It's like testing different scenarios to see how robust your financial decision is under various conditions.

Usage Context

Essential when making capital budgeting decisions, evaluating investment projects, conducting financial modeling, and assessing project risks before committing resources.

Common Confusions

• Confusing sensitivity analysis with scenario analysis - sensitivity typically changes one variable at a time
• Thinking that high sensitivity always means high risk - it depends on the likelihood of the variable changing
• Assuming all variables should be tested equally - focus on the most uncertain or impactful inputs
• Misinterpreting results as predictions rather than understanding them as risk indicators