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