What is sensitivity analysis in capital budgeting?

Capital budgeting involves evaluating potential investment projects to determine their financial viability. Risk analysis techniques are essential in this process to understand how uncertainties might affect project outcomes. Sensitivity analysis is a widely used technique for this purpose.

• Change in NPV due to change in an input variable (A) accurately defines sensitivity analysis. It systematically examines how a project's Net Present Value (NPV) or Internal Rate of Return (IRR) changes when a single key input variable (such as sales volume, unit price, or cost of capital) is altered, while all other variables are held constant. This helps identify which variables have the most significant impact on the project's profitability and risk.
• Breakeven analysis (B) determines the point at which total costs and total revenues are equal, not the impact of variable changes on NPV.
• Regression analysis (C) is a statistical method used to model relationships between variables, not a direct capital budgeting risk assessment technique in this context.
• Simulation analysis (D), like Monte Carlo simulation, involves changing multiple input variables simultaneously based on probability distributions to generate a range of possible outcomes, which is a more complex approach than sensitivity analysis's one-variable-at-a-time focus.