With two weeks to the ACCA FM & AFM CBE, let me continue my exam support blogs with a topic common to both exams.
When carrying out investment appraisal we rely on forecast data. By their very nature, these are uncertain.
Sensitivity analysis is a way of answering the classic question of what if this variable was wrong?
In both FM & AFM the variable that is tested the most is the selling price. The fact that this is an external value and the source of the income for the project makes it an obvious choice.
What you need to compute & interpret is the sensitivity margin %. This is the NPV/PV of the cash flows linked to sales expressed as a %.
Take a care with the denominator. Selling price effects sales revenue and this is obvious. But don’t forget the tax paid on revenue and when this is paid.
Less obvious and often incorrectly ignored are the working capital flows if based upon the changes in sales revenue.
Finally the comment. Let’s say the sensitivity margin was 1.36%. We are saying a fall in the selling price of 1.36% will cause the NPV to move from its current value to nil based upon the ceteris paribus (all other variables do not change).