What is Sensitivity Analysis?

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Sensitivity analysis shows how different values of an independent variable affect a dependent variable under a given set of assumptions. Companies use sensitivity analysis to identify opportunities, mitigate risk, and communicate decisions to upper management.Sensitivity analysis is deployed in business and economics by financial analysts and economists and is also known as a "what-if" analysis.

Definition

Sensitivity analysis shows how the values of different independent variables affect a dependent variable under specific assumptions. Companies use sensitivity analysis to identify opportunities, mitigate risks, and communicate decisions to senior management. It is also known as 'what-if analysis'.

Origin

The concept of sensitivity analysis originated in the mid-20th century and became popular with the advancement of computer technology. Initially used in economics and engineering, it later found widespread application in finance to aid businesses in decision-making under uncertainty.

Categories and Features

Sensitivity analysis is mainly divided into univariate and multivariate sensitivity analysis. Univariate analysis examines the impact of changes in one independent variable on the outcome, while multivariate analysis considers changes in multiple variables simultaneously. Univariate analysis is simple and easy to perform but may overlook interactions between variables; multivariate analysis is more complex but provides a more comprehensive perspective.

Case Studies

Case 1: A technology company used sensitivity analysis to assess the impact of market demand changes on sales revenue before launching a new product. By adjusting assumptions about market demand, the company could predict financial performance under different scenarios, optimizing its pricing strategy. Case 2: An energy company used sensitivity analysis to evaluate the impact of oil price fluctuations on the profitability of a new project. By analyzing different assumptions about oil prices, the company could develop a more resilient investment plan.

Common Issues

Common issues include misunderstandings about variable selection and over-reliance on results. Investors might incorrectly choose unrelated variables for analysis, leading to inaccurate results. Additionally, over-reliance on sensitivity analysis results may overlook other important factors, such as market trends and competitive dynamics.

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