Deterministic Sensitivity Analysis

Now we can evaluate how each of the uncertainties affect the resulting NPV of the whole project.

Tornado diagrams offer an effective tool for representing results of the deterministic sensitivity analysis. First, the all the variables in the value model are set to the "Base" value. The resulting NPV is the "Base Case" value for the alternative.  Then, for each of the variables in turn, the model is evaluated at the low value of the variable and then at the high value of the variable (with all other parameters kept at their base value). The difference between the low and high value of the model is a measure of how sensitive the problem is to change in that variable.
 

Plan Alpha

The company will enjoy a moderate NPV of this plan without much variance. The NPV is not affected very much by the uncertainties.  Market Success has the highest impact on the value in this case.  Note that when the Average Change in Price is at its high value, the NPV is small and vice versa.  In this case the drop in price reduces the revenue but does not stimulate enough demand to compensate this loss.
 
Tornado Diagram For Plan Alpha
 
 
 

Plan Beta

This alternative offers a higher Base Case NPV than Plan Alpha but it is clearly more risky: the NPV almost drops to zero when the Market Success is low. The larger swing of the bars on the diagram shows that the NPV will be significantly affected by the variables. However, Market Success and Change in Price would have the most impact on the resulting value.
 
 Tornado Diagram for Plan Beta
 
 

 

Plan Gamma

Even though the Base Case Value for this alternative is rather high, there can be a great risk involved in pursuing it. When the Market Success is "Low", it drops to a negative value.

An interesting thing happens here: for both low and high values of Change in Price variable, the NPV of the alternative is smaller than for the base-case Change in Price.  It can be explained easily: if the price drops by a large amount per year the company will enjoy higher demand, but lose on the revenues. When the price does not drop by much, the demand will not be there. The base-case value balances the two effects: the price is high enough to bring in sufficient revenue and is low enough to attract customers.
 

 Tornado Diagram for Plan Gamma
 
 

 

Conclusions

There is no deterministic dominance among the alternatives - none of the alternatives is clearly better or worse than others. Therefore it is necessary to continue on with the probabilistic analysis.

The tornado diagrams show that the Change in Cost uncertainty does not seriously affect the NPV. This means that in further analysis it is possible to set its value to the "Base" value and consider it as constant. However, Market Success and Change in Price have to be investigated further in the probabilistic analysis.
 

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