Describe how sensitivity analysis might be used to evaluate

Describe how sensitivity analysis might be used to evaluate and manage risk in a business scenario or investment opportunity

Solution

A sensitivity analysis determines how different values of an independent variable impact a particular dependent variable under a given set of assumptions. Sensitivity analysis is also referred to as \'what-if\' or simulation analysis and is a way to predict the outcome of a decision given a certain range of variables. By creating a given set of variables, an analyst can determine how changes in one variable impact the outcome.

Sensitivity analysis helps a business estimate what will happen to the project if the assumptions and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or estimates in a calculation to see the impact on the project\'s finances. In this way, it prepares the business\'s managers in case the project doesn\'t generate the expected results, so they can better analyze the project before making an investment.

Sensitivity analysis changes one assumption or estimate at a time to see how the results change.

For example, a business may expect to earn $500, $1,000 and $1,000 in the first three years of a project. If the business makes an initial investment of $2,500, it will recoup its expenses in three years. However, the project may perform better than expected, generating $2,000 yearly in its second and third year. The business will then break even in two years.