In capital Budgeting what does sensitivity analysis do?
A. Examines the increase in cost project when the cost of capital increases.
B. Since 10th profits to changes in mortgage.
c. It examines the sensitivity of management to the possibility that a project will be rejected
D. it examibes hiw sensitive net present value calculation is to change an underlying assumptions..
The correct answer and explanation is:
The correct answer is D. It examines how sensitive net present value calculation is to changes in underlying assumptions.
Explanation:
Sensitivity analysis in capital budgeting is a tool used to assess the risk and uncertainty of a project’s financial viability. It focuses on how changes in key assumptions or variables affect the outcome, particularly the net present value (NPV). In capital budgeting, NPV is a key metric used to determine the profitability of a project by comparing the present value of cash inflows to the present value of cash outflows. However, NPV is highly sensitive to certain assumptions, such as the cost of capital, sales forecasts, operating costs, and expected cash flows.
Through sensitivity analysis, a company can simulate different scenarios by varying one or more of these assumptions to see how they impact the NPV. For example, a project may appear profitable at a certain discount rate, but if the cost of capital increases or expected sales decrease, the NPV might become negative. Sensitivity analysis helps decision-makers understand the potential risk of a project failing under different circumstances.
This analysis provides valuable insights into which assumptions are most critical to a project’s success. If a small change in an assumption leads to a significant change in NPV, the project may be considered high-risk. On the other hand, if the NPV remains relatively stable despite changes in assumptions, the project might be viewed as more robust and less sensitive to uncertainty.
In practice, sensitivity analysis can be a crucial part of the decision-making process. It helps companies make informed choices about which projects to pursue, prioritize, or abandon, especially when facing financial constraints or uncertain market conditions. By assessing the sensitivity of key variables, businesses can better prepare for potential changes in the business environment.