## Sensitivity Analysis

One way to glean a sense of the possible outcomes of an investment is to perform a sensitivity analysis. This analysis determines the effect on NPW of variations in the input variables (such as revenues, operating cost, and salvage value) used to estimate after-tax cash flows. A sensitivity analysis reveals how much the NPW will change in response to a given change in an input variable. In a calculation of cash flows, some items have a greater influence on the final result than others. In some problems, we may easily identify the most significant item. For example, the estimate of sales volume is often a major factor in a problem in which the quantity sold varies among the alternatives. In other problems, we may want to locate the items that have an important influence on the final results so that they can be subjected to special scrutiny.

Sensitivity analysis is sometimes called "what-if" analysis because it answers questions such as: What if incremental sales are only 1000 units, rather than 2000 units? Then what will the NPW be? Sensitivity analysis begins with a base-case situation, which is developed using the most-likely values for each input. Then we change the specific variable of interest by several specific percentages above and below the most-likely value, holding other variables constant. Next, we calculate a new NPW for each of these values. A convenient and useful way to present the results of a sensitivity analysis is to plot sensitivity graphs. The slopes of the lines show how sensitive the NPW is to changes in each of the inputs: the steeper the slope, the more sensitive the NPW is to a change in the particular variable. It identifies the crucial variables that affect the final outcome most. We will use Example 17.5.1 to illustrate the concept of sensitivity analysis. 