Capital Budgeting under Risk and Uncertainties^137
Evaluation
Sensitivity analysis, a popular method for assessing risk, has certain merits:
l It forces management to identify the underlying variables and their inter-rela-
tionships.
l It shows how robust or vulnerable a project it to changes in the underlying
variables.
l It indicates the need for further work. If the net present value or internal rate
of return is highly sensitive to changes in some variable, it is desirable to gather
further information about that variable.Figure 6.6: Behaviour of NPV for Unfavourable Percentage Variations of r and P
Sensitivity analysis, however, suffers from severe limitations:
l It may fail to provide leads-if sensitivity analysis merely presents a complicated
set of switching values it may not shed light on the risk characteristics of the
project.
l The study of the impact of variation is one factor at a time, holding other factors
constant, may ìnot be very meaningful when the underlying factors are likely to
be interrelated. What sense does it make to consider the effect of variation in
price while holding quantity (which is likely to be closely related to price) un-
changed?5 10 15 20
Percentage
unfavourable variation60
40
2020
40
60
80
100
120
140
160
180
200
220
240
260
280
300PNPV
(ë000)