Economics Capital Budgeting Questions Medium
Sensitivity analysis is a technique used in capital budgeting to assess the impact of changes in key variables on the financial viability of a project. It involves analyzing how sensitive the project's net present value (NPV) or internal rate of return (IRR) is to variations in factors such as sales volume, costs, discount rate, or other relevant variables.
The process of sensitivity analysis typically involves creating different scenarios by adjusting one variable at a time while keeping all other factors constant. By doing so, decision-makers can evaluate the potential outcomes and risks associated with different assumptions or changes in the project's environment.
Sensitivity analysis helps in identifying the most critical variables that significantly influence the project's profitability and overall feasibility. It allows managers to understand the potential impact of uncertainties and make informed decisions based on a range of possible outcomes.
Furthermore, sensitivity analysis can also assist in determining the breakeven point, which is the level at which the project's NPV becomes zero. This information is valuable for assessing the project's risk and determining the minimum level of performance required for the project to be financially viable.
Overall, sensitivity analysis is a valuable tool in capital budgeting as it helps decision-makers understand the potential risks and rewards associated with a project, enabling them to make more informed investment decisions.