(ii) Briefly explain the extent to which the application of sensitivity analysis might be

Question

(ii) Briefly explain the extent to which the application of sensitivity analysis might be useful in deciding

which refrigeration system to purchase and discuss the limitations inherent in its use. (3 marks)

Answer 1

正确答案：
(ii) Sensitivity analysis could be used to assess how responsive the NPV calculated in part (a) in respect of each decision
option change is to changes in the variables used to calculate it. The application of sensitivity analysis requires that the
net present values are calculated under alternative assumptions in order to determine how sensitive they are to changing
conditions. In this particular example then a relatively small change in the forecast cash flows might lead to a change
in the investment decision. The application of sensitivity analysis can indicate those variables to which the NPV is most
sensitive and the extent to which these variables may change before an investment results in a negative NPV. Thus the
application of sensitivity analysis may provide management with an indication of why a particular project might fail. The
directors of Stay Cool Ltd should give consideration to the potential variations in the independent variables which feature
in the decision-making process such as:
– estimated revenues
– estimated operating costs
– estimated working lives
– estimated repair costs
– the estimated discount rate i.e. cost of capital of each alternative investment.
Sensitivity analysis has some serious limitations. The use of the method requires changes in each variable under
consideration are isolated. However management may be focused on what happens if changes occur in two or more
critical variables. Another problem relating to the use of sensitivity analysis to forecast outcomes lies in the fact that it
provides no indication of the likelihood of the occurrence of changes in critical variables.