3.2 A given change in one of the variables will cause change in the NPV or
IRR of a project. Analysis of change is called as sensitivity analysis.
Only thing is we have to choose such variables which can influence NPV
or IRR.
3.3 By causing change in one of the variables like volume, price, cost etc., the
NPV or IRR of the project must be recalculated and an appropriate
decision taken. The sales volume and the unit sale price is a most
sensitive variable, because even the slightest change in them, will result in
greater change in the NPV or IRR
3.4 The major advantage of sensitivity analysis is that it exposes inappropriate
forecasts. In other words, the decision maker will be able distinguish
between what is relevant and what is not relevant. He will clearer
regarding the impact of different variables on cash flows. It will also help
him tackle weak spots.
3.5 Sensitivity analysis is used to study the impact of combination of variables
in different proportions on NPV or IRR of the project. This is know as
Scenario Analysis.
- Probability assignment
4.1 The trouble is always that of forecasting future cash flows. Even if cash
flow is forecast, the second problem is that of reliability. The phrase used
is always “most likely” rather than “exactly”. The question is ‘how to
arrive at the "most likely" figure? This depends on the probability.
Measuring an individual's opinion about the likelihood of an event
occurring, is known as probability. Estimates of cash flows are made
under "best guess", "high guess" and "low guess" with the percentage of
probability. This probability will help us measure risk. Instead of taking
probability as Best, High or Low Guess, it is safer to take it on a large
number of points under independent, identical situations. The probability
based on this is known as objective probability.
4.2 When cash flow is estimated, one may assign risk for each level of cash
flow. In case of non-repetitive projects, apart from risk, it is associated
with the problem of high degree of uncertainty.
4.3 After assigning probabilities to future events, the monetary values of the
possible events should be multiplied with the probabilities of expected
monetary value.
