Finance
Textbooks
Boundless Finance
The Role of Risk in Capital Budgeting
Scenario and Simulation Assessments
Finance Textbooks Boundless Finance The Role of Risk in Capital Budgeting Scenario and Simulation Assessments
Finance Textbooks Boundless Finance The Role of Risk in Capital Budgeting
Finance Textbooks Boundless Finance
Finance Textbooks
Finance
Concept Version 5
Created by Boundless

Sensitivity Analysis

Sensitivity analysis determines how much a change in an input will affect the output.

Learning Objective

  • Describe how sensitivity analysis is used to make investment decisions


Key Points

    • Since variations from the base assumptions are expected, businessmen and women want to know how much their output (eg., revenue) will be affected by the variations.
    • Sensitivity analysis helps find the optimal levels for inputs (eg., raw material prices, number of employees, sales price) .
    • Sensitivity analysis is a statistical tool based on seeing how inputs and parameters affect outputs. Generally, each input is changed one at a time to see how it affects output. However, this does not account for interconnectedness between inputs; they may not be independent variables.

Terms

  • sensitivity analysis

    the study of how the uncertainty in the output of a mathematical model or system can be apportioned to different sources of uncertainty in its inputs

  • parameter

    A variable kept constant during an experiment, calculation, or similar.


Full Text

Capital budgeting is, by definition, forward looking. When dealing with expected resources and demands, uncertainty is a major factor. Sensitivity analysis is a statistical tool that determines how consequential deviations from the expected value occur. Sensitivity Analysis deals with finding out the amount by which we can change the input data for the output of our linear programming model to remain comparatively unchanged. This helps us in determining the sensitivity of the data we supply for the problem. It also helps to determine the optimal levels of each input.

Sensitivity analysis can be useful for a number of reasons, including:

  • Support decision making or the development of recommendations for decision makers (e.g., testing the robustness of a result).
  • Enhance communication from modelers to decision makers (e.g., by making recommendations more credible, understandable, compelling or persuasive).
  • Increase understanding or quantification of the system (e.g., understanding relationships between input and output variables).
  • Model development (e.g., searching for errors in the model).

In order to conduct a sensitivity analysis, all of the inputs and parameters are connected via an algorithm to produce the output. For example, a model of the inputs and parameters for a company interest in creating a new product may include information about expected availability of raw material, inflation rates, and number of employees working in R&D. The output would be the profit generated by the new product. The sensitivity analysis entails changing each variable and seeing how that changes the output . Generally, only one variable is changed at once, with all of the others fixed at their base value. This makes it easy to see how much a variable affects the output. However, not all of the inputs may be independent so changing inputs one at a time does not account for interaction between the inputs.

Sensitivity of a Variable

Sensitivity analysis determines how much an output is expected to change due to changes in a variable or parameter. In this case, the output (y-axis) decreases exponentially with an increase in the input (x-axis). This is mapped out for each input.

[ edit ]
Edit this content
Prev Concept
Risk and Return Considerations
Scenario Analysis
Next Concept
Subjects
  • Accounting
  • Algebra
  • Art History
  • Biology
  • Business
  • Calculus
  • Chemistry
  • Communications
  • Economics
  • Finance
  • Management
  • Marketing
  • Microbiology
  • Physics
  • Physiology
  • Political Science
  • Psychology
  • Sociology
  • Statistics
  • U.S. History
  • World History
  • Writing

Except where noted, content and user contributions on this site are licensed under CC BY-SA 4.0 with attribution required.