CHAPTER TWO

SENSITIVITY ANALYSIS USING EXCEL

Scenario manager, other sensitivity analysis features, simulation using excel different statistical
distributions used in simulation generating random numbers that follow a particular distribution,
building models in finance using simulation.

What is Sensitivity analysis?

Sensitivity Analysis is a tool used in financial modeling to analyze how the different values of a
set of independent variables affect a specific dependent variable under certain specific
conditions. In general, sensitivity analysis is used in a wide range of fields, ranging from biology
and geography to economics and engineering. It is especially useful in the study and analysis of a
“Black Box Process” where the output is an opaque function of several inputs. An opaque
function or process is one which, for some reason, can’t be studied and analyzed. For example,
climate models in geography are usually very complex. As a result, the exact relationship
between the inputs and outputs are not well understood. Computer-based model used to develop
financial projections using historical data and assumptions.

Points to Check on a Financial Model: Historical data

 Should have at least 3 years of historical operational and financial data

 Historical financial data must match data in audited financial statements
 Model should include figures that show evolution of key financial and operational
indicators
 It should be easy to identify reasons for any unusual changes in evolution of key
indicators
 One worksheet that shows key indicators (e.g. EBITDA)
 One worksheet where main assumptions can be seen and changed.

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Data inputs and assumptions are drawn into calculation worksheets and converted into useful
conclusions and indicators in the Presentation worksheets. The effects on Presentation
worksheets inform the decision-making process.

Consistency of Physical and Financial Flows

 A well-functioning financial model must be able
to: project the company’s physical flows such as:
 number of customers
 Volumes of water produced and treated
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  changes in fixed assets
 project the company’s financial flows such as:
 rates for each tariff category
 required investments
 interest expenses
 reconcile the physical flows with the financial flows
What-If Analysis

A Financial Sensitivity Analysis, also known as a What-If analysis or a What-If simulation

exercise, is most commonly used by financial analysts to predict the outcome of a specific action
when performed under certain conditions.

Financial Sensitivity Analysis is done within defined boundaries that are determined by the set of
independent (input) variables.

For example, sensitivity analysis can be used to study the effect of a change in interest rates on
bond prices if the interest rates increased by 1%. The “What-If” question would be: “What
would happen to the price of a bond If interest rates went up by 1%?” This question can be
answered with sensitivity analysis.

The analysis is performed in Excel, under the Data section of the ribbon and the “What-if
Analysis” button, which contains both “Goal Seek” and “Data Table”.

Sensitivity Analysis Example

John is in charge of sales for HOLIDAY CO, a business that sells Christmas decorations at a
shopping mall. John knows that the holiday season is approaching and that the mall will be
crowded. He wants to find out whether an increase in customer traffic at the mall will raise the
total sales revenue of HOLIDAY CO and, if so, then by how much. The average price of a

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packet of Christmas decorations is $20. During the previous year’s holiday season, HOLIDAY
CO sold 500 packs of Christmas decorations, resulting in total sales of $10,000. After carrying
out a Financial Sensitivity Analysis, John determines that a 10% increase in customer traffic at
the mall results in a 7% increase in the number of sales.

Using this information, John can predict how much money company XYZ will generate if
customer traffic increases by 20%, 40%, or 100%. Based on John’s Financial Sensitivity
Analysis, such increases in traffic will result in an increase in revenue of 14%, 28%, and 70%,
respectively.

SENSITIVITY ANALYSIS USING EXCEL:

The main goal of sensitivity analysis is to gain insight into which assumptions are critical, i.e.,
which assumptions affect choice. The process involves various ways of changing input values of
the model to see the effect on the output value. In some decision situations you can use a single
model to investigate several alternatives. In other cases, you may use a separate spreadsheet
model for each alternative.
MANUAL WHAT-IFANALYSIS:
Using this approach, you enter values into cells C4:C6 and see what the effect is on net cash
flow. For example, with the predetermined price of $29, you may think that Units Sold will be in
the range between 500 and 900 units. Keeping other input assumptions at base case, the
corresponding Net Cash Flows are $1,500 and 56,900. When we vary a single input assumption.
Keeping all other input assumptions at their base case values, we say we are doing “one at a
time” or “single factor” sensitivity analysis.

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 A B C
1 controllable input
2 unit price 29
3 Uncontrollable inputs
4 units sold 700 Formula>>=D5*(D3-D6)-D7
5 unit variable cost 8

6 Fixed Costs 12,000.00

7 performance Measure

8 Net Cash Flow 2,700.00

THRESHOLD VALUES:
You are usually interested in how the input assumptions eventually affect the recommended
choice in the decision problem. In the professor’s summer decision problem, the software
alternative (uncertain payoff) is being compared with teaching MBA’s (Payoff $4,300) and
taking a vacation (payoff $0). An example of a threshold is to ask “How many units must I sell to
do better with software than with teaching.”
In other words, in the software spreadsheet model, what must the value of units sold in cell c4 be
so that the value of Net Cash Flow in cell C8 is equal to $4,300? You could find the answer by
involving one unknown. Or, you could let Excel find the answer.
GOAL SEEK:
To answer the question using an Excel feature, choose Tools| Goal Seek. In Excel 2007 or 2010,
choose Data | What-if Analysis| Goal Seek. In Excel terminology, you want to “set cell” CS “To
value” 4300 ”By changing cell” C4 Figure 2.2 shows the entries when you point to cells C8 and
C4, in which case they appear in the range edit boxes as absolute references, indicated by the
dollar signs.

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Alternatively, you could type C8 and C4 into the edit boxes instead of pointing. When you click
OK. Excel displays a Goal Seek Status message, as shown in Figure 2.3. If there is a complex or
discontinuous relationship between the changing cell and the set cell, the Goal Seek Status
message may say that it was not able to find a solution.

BREAKEVEN POINT
A special case of threshold analysis is the breakeven point, usually defined as the sales volume at
which contribution to profit and overhead equals fixed cost. In the software model, the breakeven
point is the value for Units Sold when Net Cash Flow is zero. Using Goal Seek (not shown here),
the breakeven point is found to be 571. The professor must sell at least 571 units to have higher
cash flow with the software than taking a vacation. You could also use single-factor sensitivity
analysis to determine threshold values for the other input assumptions of the model.

Goal Seek: Is useful when you know the desired output but you are unsure of the inputs to reach
that amount.

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Income statement
Sheet Historical Financial Forecast Income Statement
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Net Sales 4,367.80 4,629.90 5,000.30 5350.32 5724.84 6125.58 6554.37 7013.18 7504.10 8029.39
Cost of Goods
Solds 2,620.70 2,870.50 3,050.20 3263.70 3492.15 3736.61 3998.17 4278.04 4577.50 4897.93

Gross Profit 1,747.10 1,759.40 1,950.10 2086.63 2232.69 2388.98 2556.21 2735.14 2926.60 3131.46

SG&A Expense 715.00 787.10 900.10 909.55 973.22 1041.35 1114.24 1192.24 1275.70 1365.00
Other
Expense/(Income) (43.70) (96.40) (60.00) 0 0 0 0 0 0 0
Stock Based
Compensation 40.00 48.00 50.00 53.50 57.25 61.26 65.54 70.13 75.04 80.29

EBITDA 1,035.80 1,020.70 1,060.00 1,123.57 1,202.22 1,286.37 1,376.42 1,472.77 1,575.86 1,686.17

Depreciation 131.0 138.9 150.0

Amortization 11.0 12.0 13.0

EBIT 893.8 869.8 897.0 960.57 1,202.22 1,286.37 1,376.42 1,472.77 1,575.86 1,686.17

Interest Expense 44.1 60.1 63.8

Pretax Income 849.7 809.7 833.2 960.57 1,202.22 1,286.37 1,376.42 1,472.77 1,575.86 1,686.17

Icome Taxes 331.4 315.8 324.9 326.59 408.75 437.37 467.98 500.74 535.79 573.30

Net Income 518.3 493.9 508.3 634.0 793.5 849.0 908.4 972.0 1,040.1 1,112.9
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Reserved 39.29 25.7 37.66 44.38 55.54 59.43 63.59 68.04 72.80 77.90

Common Dividend 39.29 33.05 41.85 50.72 63.48 67.92 72.67 77.76 83.21 89.03

Preferred Dividend 7 7.9 8.7 63.40 79.35 84.90 90.84 97.20 104.01 111.29

Retained Earning 475.48 595.10 636.75 681.33 729.02 780.05 834.65

Historical
Analysis 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Sale growth Rate 6.0% 8.0% 7% 7% 7% 7% 7% 7% 7%
Cost of Goods Sold %of Sales 60.0% 62.0% 61% 61% 61% 61% 61% 61% 61%
SG& A as of % of
Sale 16.4% 17.0% 17% 17% 17% 17% 17% 17% 17%
Other as a % of
Sales -1.0% -2.1% 0% 0% 0% 0% 0% 0% 0%
SBC as a % of
Sales 0.9% 1.0% 1% 1% 1% 1% 1% 1% 1%

Tax Rate 39% 32% 34% 34% 34% 34% 34% 34% 34% 34%
Reserved as a % of
PAT 8% 5% 7% 7% 7% 7% 7% 7% 7% 7%

Dividend Pay out

Ratio 8% 6% 8% 8% 8% 8% 8% 8% 8% 8%
Preferred dividend
rate 9% 9% 10% 10% 10% 10% 10% 10% 10% 10%

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 Net Sales
9,000.00
A 8,000.00
x
7,000.00
i
6,000.00
s
5,000.00
4,000.00 7504.10 8029.39 Net Sales
T 7013.18
6125.58 6554.37
i 3,000.00 5,000.30 5350.32 5724.84
4,367.80 4,629.90
t 2,000.00
l 1,000.00
e -
1 2 3 4 5 6 7 8 9 10
Net Sales 4,367.80 4,629.90 5,000.30 5350.32 5724.84 6125.58 6554.37 7013.18 7504.10 8029.39

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Sensitivity Analysis vs. Scenario Analysis

It is important not to confuse Financial Sensitivity Analysis with Financial Scenario Analysis.
Although similar to some degree, the two have some key differences.

Sensitivity Analysis is used to understand the effect of a set of independent variables on some
dependent variable under certain specific conditions. For example, a financial analyst wants to
find out the effect of a company’s net working capital on its profit margin. The analysis will
involve all the variables that have an impact on the company’s profit margin, such as the cost of
goods sold, workers’ wages, managers’ wages, etc. The analysis will isolate each of these fixed
and variable costs and record all the possible outcomes.

Scenario Analysis, on the other hand, requires the financial analyst to examine a specific
scenario in detail. Scenario Analysis is usually done to analyze situations involving major
economic shocks, such as a global market shift or a major change in the nature of the business.

After specifying the details of the scenario, the analyst would then have to specify all of the
relevant variables, so that they align with the scenario. The result is a very comprehensive
picture of the future (a discrete scenario). The analyst would know the full range of outcomes,
given all the extremes, and would have an understanding of what the various outcomes would be,
given a specific set of variables defined by a specific real-life scenario.

Advantages of Financial Sensitivity Analysis

There are many important reasons to perform sensitivity analysis:

 Sensitivity analysis adds credibility to any type of financial model by testing the model
across a wide set of possibilities.
 Financial Sensitivity Analysis allows the analyst to be flexible with the boundaries within
which to test the sensitivity of the dependent variables to the independent variables. For
example, the model to study the effect of a 5-point change in interest rates on bond prices
would be different from the financial model that would be used to study the effect of a
20-point change in interest rates on bond prices.
 Sensitivity analysis helps one make informed choices. Decision-makers use the model to
understand how responsive the output is to changes in certain variables. Thus, the analyst
can be helpful in deriving tangible conclusions and be instrumental in making optimal
decisions.

Best Practices in Sensitivity Analysis

#1 Layout in Excel

Layout, structure, and planning are all important for good sensitivity analysis in Excel. If a
model is not well organized, then both the creator and the users of the model will be confused
and the analysis will be prone to error.

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The most important points to keep in mind for layout in Excel include:

 Place all assumptions in one area of the model

 Format all assumptions/inputs in a unique font color so that they are easy to identify
 Think carefully about what to test – only the most important assumptions
 Understand the relationship (correlation) between dependent and independent variables
(linear? – nonlinear?)
 Create charts and graphs that enable users to easily visualize the data
 Create a separate area for the analysis by using grouping (see example below)

#2 Direct versus indirect methods

The direct method involves substituting different numbers into an assumption in a model.

For example, if the revenue growth assumption in a model is 10% year-over-year (YoY), then
the revenue formula is = (last year revenue) x (1 + 10%). In the direct approach, we substitute
different numbers to replace the growth rate – for example, 0%, 5%, 15%, and 20% – and see
what the resulting revenue dollars are.

The indirect method (as shown below) inserts a percent change into formulas in the model,
instead of directly changing the value of an assumption.

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Using the same example as above, if the revenue growth assumption in a model is 10% year-
over-year (YoY), then the revenue formula is = (last year revenue) x (1 + 10%). Instead of
changing 10% to some other number, we can change the formula to be = (last year revenue) x (1
+ (10% + X)), where X is a value contained down in the sensitivity analysis area of the model.

#3 Tables, charts, and graphs

Sensitivity analysis can be challenging to comprehend even by the most informed and
technically savvy finance professionals, so it’s important to be able to express the results in a
manner that’s easy to comprehend and follow.

Data tables are a great way of showing the impact on a dependent variable by the changing of
up to two independent variables. Below is an example of a data table that clearly shows the
impact of changes in revenue growth and EV/EBITDA multiple on a company’s share price.

What is Scenario Planning?

Scenario Planning in Strategic Management:

A 'scenario' is a likely shape of the firm's industry in the future. Planning by itself is a process
of learning. Scenario Planning is a technique which enables the managers to check how the
strategies that they have designed are likely to fare in the future. It also allows them to design
contingency plans and also to gauge the robustness of the designed strategy.

According to Schoemaker, "Scenario planning is a disciplined method for imagining possible

futures”. It is "an internally consistent view of what the future might turn out to be". With the
help of scenario planning, the strategic leaders can identify the flaws and loopholes in the
organizational system as well as in the formulated strategies. This helps the strategists to
formulate alternative strategies for dealing with the weaknesses of the organization.

Scenario planning helps the management team to foresee the problems and weaknesses with
respect to the 3Ps - Policies, Plans and Programs. Organizational PPPs are inherently rigid as
they are based on a process of extrapolation and are of self validating nature.

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Process of Scenario Planning
Followings are the Scenario planning process:

1. Decide the Time Duration and Scope:

The first step of scenario planning is to decide time duration of the analysis. After this, strategic
managers decide the scope in which the scenario planning has to be carried out. The time
duration of scenario planning depends upon many factors such as the time taken to complete the
product life cycle, new technology about to arrive in market, new product to be launched in
market, etc. On the other hand, the scope of scenario planning encompasses products, services,
markets, geographic location, etc., which the organization deals in. After deciding the time
duration and scope, the strategists decide the information which is needed for the betterment of
the organization.

2. Identify the Interest, Power and Influence of Stakeholders:

The next step after deciding the tine-frame and scope is to identify the significant stakeholders.
These stakeholders influence the organization as well as get influenced by the activities of the
organization. Hence, the strategies need to understand the level of their influence and power. For
this, the strategic managers need to identify different interests of stakeholders so as to estimate
the impact they are Likely to have on the organization.
3. Identify the Environmental Factors:
Once the key issues of time frame and scope of planning are defined, the organization needs to
look at all factors like political, economic, social, technological and industry which are likely to
impact the organization. The effect of these factors may be positive, negative or unknown.
4. Recognize the Major Uncertainties:
As soon as the factors influencing current organizational functions are identified, the next thing
to do is to recognize the major uncertainties that might occur and influence the business
operations. The organization is vulnerable to the effect of many uncertain events. The
environmental factors responsible for those uncertainties should be recognized along the driving
forces of that particular industry. The organization needs to develop a hypothesis for each of
these uncertainties so that their effect can be mitigated in the future.
5. Develop Preliminary Scenario:

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After collecting all the essentials, the strategists become capable of developing the preliminary
scenario for the organization. Here, the strategic managers consult with the responsible
dignitaries as well as the stakeholders of the organization about the positive and negative
influences of business trends on the organization. Once they gather their views, they combine
and compare all the positive views on one side leaving the negative ones on the other. This step
highlights the points at which the organizations need to focus to minimize the negative impact.
6. Monitor the Trends and Choose the Ultimate Scenario:
At this stage the organization needs to check if the trends that have been identified are consistent
with the time frame that has been decided. Those trends that are not in synchronization with the
time frame should be removed. The outcomes also should also not be inconsistent with one
another. It also needs to be seen if the concerns of the stakeholders have been addressed. In this
phase, several, scenarios should be developed and the prime task should be to identify the most
significant and ultimate scenario among alternative scenarios.
7. Construct Learning Scenarios:
In this phase, the strategists develop the learning themes so that they can draw-out the relevant
patterns and recognize the possible desired outcomes. These learning scenarios can be labeled as
per their characteristics. This helps individuals in the organization to understand these trends and
to remember them. These learning scenarios also help in identifying future research needs of the
organization.
8. Conduct Further Research:

In this stage, the organization undertakes further research to get greater clarity on the trends and
uncertainties. Organizations typically have knowledge about their immediate competitive
environment but are not so well versed with emerging trends in the industry. It is important to
study and understand these trends as they could impact the company at any subsequent stage.
The researchers analyze the anticipated changes that may occur such as change in technology,
change in consumer behavior, and change in government laws, etc.

9. Re-Scrutinize the Organizational Processes:

After extensive research work, the strategists need to re-scrutinize the uniformity of the
organizational processes and anticipate whether validating the trends and patters will actually
lead to the desired outcome or not. Here an organization may want to develop quantitative
models for formalizing the various concepts used in the scenarios.

10. Evolve towards Decision Scenarios:

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The ultimate test of scenario building is if it can help the organization in its decision-making and
in the generation of new ideas. This helps the organization to check the effectiveness of the
strategy formulated. At this step, it also makes sense to check the previous steps (1-8) and to see
if the scenarios developed actually help the organization to counter the issues it faces or not.

Advantages of Scenario Planning

1. It improves the quality and makes robust policies, plans and programmes for the
organization.
2. It develops a sense of participation in employees and utilizes the retrieved information to
formulate certain scenarios.
3. Scenario planning provides both rigidity, and creativity in the organizational activities.
This results in generating new ideas and insights on important developments in the firm's
external environment.
4. It compels the decision-makers in the organization to come out of their comfort zones. It
forces them to evaluate their business paradigms and to identify trends in the macro
environment. It thus widens the strategic vision of the organization.

Disadvantages of Scenario Planning

1. Scenario planning is theoretical in nature without any scientific implication. This makes
it a vague process.
2. The practical implementation of scenario planning is hardly verified by the academic
researchers.
3. Strategic leaders generally anticipate a single future scenario as they are not able to
anticipate several future scenarios simultaneously. This leads to reduction in the
flexibility that can be attained by having by having multiple scenarios. Anticipating a
single scenario 'may also reduce the chances of learning.
4. While anticipating a single future scenario is disadvantageous, assuming several future
scenarios is also not beneficial. Although it simplifies the complexity of future scenarios,
it also creates misunderstandings in the planning process.
5. The success of the exercise depends on the process in that has been execute, e.g., how are
the teams made, what are the roles of the team members, etc.
6. Generally, it is not properly combined with the planning and budgetary systems in the
organization.
7. It consumes a lot of time and effort.
8. Scenario planning has high expenditure in terms of costs and resources.

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