Capital budgeting refers to the process by which a business determines whether to take on a certain project. The analysis involves estimating the amount of money the business has to invest and the amount of revenue the project will generate. Sensitivity analysis provides additional insight for the business to make the investment decision.
A business may use various methods to determine the financial effects of a certain project. The business may calculate the amount of time it will take for the project to generate enough income to cover the investment expenses. The company may also estimate the cash flow from the project over time and calculate whether the project will lead to a profit or a loss. Another way is to calculate the discount rate at which the project will break even.
All methods of capital budgeting involve making assumptions and estimates about the project's future performance. The business's managers then use the results of the calculations to make their decisions. However, the assumptions and estimates may turn out to be inaccurate and the project may produce unexpected results. Instead of turning a profit in the second year of operations, for example, the business may only break even because of bad economic conditions.
Sensitivity analysis helps a business estimate what will happen to the project if the assumptions and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or estimates in a calculation to see the impact on the project's finances. In this way, it prepares the business's managers in case the project doesn't generate the expected results, so they can better analyze the project before making an investment.
In capital budgeting calculations, sensitivity analysis changes one assumption or estimate at a time to see how the results change. For example, a business may expect to earn $500, $1,000 and $1,000 in the first three years of a project. If the business makes an initial investment of $2,500, it will recoup its expenses in three years. However, the project may perform better than expected, generating $2,000 yearly in its second and third year. The business will then break even in two years.
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