Sensitivity Analysis

Submitted By
Muneeb Ul Haq
Reg # 1684119
MPM 2 B
Introduction
Decision makers need tools to help them use historical data to predict, as best they
can, the future impact of their decisions. There are many different ways decision
makers can try to predict the future outcomes of their decisions. They can, and
many do, just guess, or in kinder terms, go with their gut. Some may consider the
past and look for similar decisions and what outcomes those
decisions had.
If they're really clever, they'll look for differences in the current conditions and the
historical example they are using and consider how that may impact the outcomes.
And, if they have the right information and understanding, they can use sensitivity
analysis.

Definition
Sensitivity analysis is a technique used to determine how different values of an
independent variable impact a particular dependent variable under a given set of
assumptions. A sensitivity analysis is created to understand the impact a range of
variables has on a given outcome. In this we investigate the impact of changes in
project variables on the base-case (most probable outcome scenario).

Purpose of Sensitivity Analysis

 Helps in identifying the key variables which influence the project cost
 To investigate the consequences of likely adverse changes in these key
variables
 To assess whether project decisions are likely to be affected by such changes
 To identify actions that could mitigate possible adverse effects on the
project.
 In many models, we need to make assumptions we cannot test. Sensitivity
analysis examines dependence of results on these assumptions

Methodology
We conduct sensitivity analysis by an approach outlined below:
 Find the base case output (Net Present Value) at the base case value (V1) of
the input for which we intend to measure the sensitivity (discount rate). We
keep all other inputs in the model (such as cash flow growth rate, tax rate,
depreciation, etc.) constant.
  Find the value of output at a new value of the input (V2) while keeping other
inputs constant.
 Find the percentage change in the output and the percentage change in the
input.
 Find sensitivity by dividing the percentage change in output by the
percentage change in input.

Representation of Sensitivity
The results of sensitivity Analysis are shown in a graphical representation named
as Tornado Diagram or Butterfly diagram. The Tornado shape of the diagram
represents the most important and influential factors on the top and the least
contribution factors on bottom of the chart.

The Y-axis show all the variables that are affecting the outcome value and the
X-axis show the effect of those variables

Example 1:
Great Wall Beatle is a company that operates in the mountainous country of
Zhongua and constructs tunnels for the country's major road developers.
The company is in the process of submitting its bid for construction of the
country's longest tunnel on the interstate expressway. The tunnel would be 20km
long and the company bids to receive $1 from each vehicle that crosses the tunnel
for 100 years. The company's Chief Engineer came up with an NPV of
$1,218Million for the project assuming cash flows are received at the year end.
His estimates include:

 Weighted average cost of capital of 11%

 Daily traffic of 1,000,000 vehicles
 Daily operating expenses as 3% of total revenue
 Initial cost of $2 billion.
Find how sensitive the net present value is to each input?

Solution
To find sensitivity of Net Present Value (NPV) to the estimate of WACC, calculate
NPV assuming WACC is 12.1% instead of 11%
Following are kept constant while calculating NPV
 Daily traffic at 1,000,000
 Daily operating expenses at 3%
 Initial costs at $2,000 million
This gives us a net present value of $926 million.
Percentage change in output is -24.01% (($926 million × $1,218 million) ÷ $1,218
million) while the change in input is 10% ((11.1% − 11%) ÷ 11%). Percentage
change in output per 1% change in input is -2.4
Similarly, we find that sensitivity estimates for daily traffic, daily operating
expenses and initial costs are 2.64, -0.08 and -1.64.
Conclusion
The calculations not only show the relationship between output and input but it
also tells how sensitive output is to each input. A negative sensitivity means that
the output (net present value) decreases with an increase in that input (such as
discount rate).
We conclude that the net present is most sensitive to the estimate of daily traffic
and least sensitive to the estimate of daily operating expenses. Knowing the
importance of the daily traffic figure in the output, the company should try to
estimate the daily traffic with as much accuracy as possible.
Reference 1
 http://www.investopedia.com/terms/s/sensitivityanalysis.asp#ixzz4foZtB79k 

Reference 2
http://xplaind.com/167040/sensitivity-analysis

Reference 3
http://study.com/academy/lesson/sensitivity-analysis-definition-uses-importance.html