How can sensitivity analysis assist in investment appraisal processes?

Sensitivity analysis assists in investment appraisal processes by assessing the impact of changes in key variables on projected outcomes.

Sensitivity analysis is a technique used in financial modelling to understand how the uncertainty in the output of a model can be apportioned to different input variables. In the context of investment appraisal, it helps to identify which variables have the most significant impact on the projected returns of an investment. This could include factors such as changes in interest rates, inflation rates, exchange rates, or operational costs.

For instance, if an investment is highly sensitive to changes in interest rates, a small increase in rates could significantly reduce the projected returns. By identifying this sensitivity, decision-makers can take steps to mitigate the risk, such as by securing a fixed interest rate or by choosing investments that are less sensitive to interest rate changes.

Sensitivity analysis also helps to test the robustness of an investment appraisal. By changing the values of key variables and observing the impact on the projected returns, decision-makers can assess how likely it is that the investment will deliver the expected returns under different scenarios. This can help to identify investments that are likely to perform well even under adverse conditions, thereby reducing the risk of the investment.

Moreover, sensitivity analysis can assist in the decision-making process by providing a range of possible outcomes rather than a single point estimate. This can help decision-makers to understand the potential upside and downside of an investment, and to make more informed decisions about whether to proceed with the investment.

In summary, sensitivity analysis is a valuable tool in investment appraisal processes. It helps to identify the key variables that have the most significant impact on the projected returns of an investment, to test the robustness of the investment appraisal, and to provide a range of possible outcomes. By doing so, it assists decision-makers in making more informed and risk-aware investment decisions.