Sensitivity analysis (“What if”):
One measure which expresses risk in more precise terms is sensitivity analysis. It provides information as to how sensitive the estimated project parameters, namely, the expected cash flow, the discount rate and the project life are to estimation errors. The analysis on these lines is important as the future is always uncertain and there will always be estimation errors. Sensitivity analysis takes care of estimation errors by using a number of possible outcomes in evaluating a project. The method adopted under sensitivity analysis is to evaluate a project using a number of estimated cash flows to provide to the decision maker an insight into the variability of the outcomes.
Sensitivity analysis provides different cash flow estimates under three assumptions –
a) The worst (i.e. the most pessimistic),
b) The expected (i.e. the most likely), and
c) The best (i.e. the most optimistic) outcomes associated with the project.
The examination of the assumptions underlying the financial projections will highlight any variables to which the business is particularly vulnerable. A detailed sensitivity analysis, applied to the profit and cash flow projections, will outline the effect of any negative changes in these variables. The accountants should be in a position, following this review, to suggest the levels of contingency that the financiers will need if there is a shortfall in the projections. This is particularly important in respect of the cash flow projections. It is obviously unfortunate if the borrowers are obliged to return to the financiers after only a short period of time because overoptimistic projections have proved invalid, and they need to raise additional finance. Again it is important that the accountants express a firm opinion as precisely as possible.
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