This is because of the relatively long timescales involved, there is more time for things to go wrong between the decision being made and the  end of project because of the size of the investment. If things go wrong, the impact can be both significant and lasting. Sometimes, a distinction is not paticularly useful for our purposes and in this chapter the two words are used interchangeably.

Sensitivity Analysis

A popular way of assessing the level of risk associated with a project is to carry out sensitivity analysis.

This method involves an examination of key input values affecting the project in paticular proposals.

Where the result on investment appraisal, using the best estimates, is positive, each input value can be examined to see by how much the estimated figure could be changed before the project becomes unprofitable for that reason alone.

For example, the NPV for an investment in a machine to produce a particular product is a positive value of £50,000. If we carry out sensitivity analysis on this investment proposal, we would consider each of the key input values in turn we would seek to find  the most advers value which each of these inputs could have before the NPV figure becomes negative. The difference between the worst value calculated and the estimated value represents the margin of safety for that particular input. By carrying out a sensitivity analysis, managers may acquire a feel for the investment project which otherwise might not be possible.