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Sensitivity and Scenario Analysis

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Explain the following concepts in relation to Capital Budgeting Techniques.
a. Sensitivity Analysis
b. Scenario Analysis

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Solution Summary

Sensitivity analysis method assess the changes in the net present value and internal rate of return of the project due to change in the variables. Scenario analysis is another approach similar to sensitivity analysis which examines the risk in a particular scenario. This post discusses both these methods in detail with example.

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Sensitivity analysis:

The sensitivity analysis is part of the management accounting that is used by the top management in decision-making process. The sensitivity analysis is used for analyzing impact of censorious and non-censorious factors and variables on financial gain of the company. The sensitivity analysis discern the critical factors and admonish the management about that ensure the effective corporate decision-making by the management (XD, 2015). This analysis method helps in identifying that which variables is highly sensitivity and which is low that helps in directing the monitoring to ensure the effectively achievement of the organizational mission and vision.
Furthermore, generally top management uses the sensitivity analysis in the process of capital budgeting to find out the possible relation between the variables such as proposed project, sales of the company, profitability of the company, liquidity condition, contribution, and working capital management of the company (Bierman and Smidt, 2014). Sensitivity analysis with the capital budgeting techniques helps in identifying the possible result to be happened with the project. Hence, the sensitivity analysis is very effective tools in corporate decision-making. In sensitivity analysis, the estimated value in calculation is changed to see the impact on the financial aspects of the project. The management is better able to analyze the project by incorporating the sensitivity analysis in the capital budgeting process (Chron, 2017).

Moreover, the sensitivity analysis is the method analyzes the changes in the net present value and internal rate of return of the project due to change in the variables. Sensitivity analysis first identify the factors or variables that have influence on the NPV of the project, defining the underlying relation between variables, and then changes in the variables to ...

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  • M.Com, University of Ajmer
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