Distinguish between the following: Sensitivity Analysis and Risk Analysis.

Both sensitivity analysis and risk analysis are the methods of evaluating risks in a capital budgeting decision. The two approaches have their own advantages and limitations and are used along with each other for risk analysis. Sensitivity Analysis Projects are sensitive to fluctuation in values of critical variables like costs of inputs, cost of funds and prices of outputs. It is important to examine how sensitive is the project to fluctuations in the values of these variables because the basic assumptions taken for projections of balance sheet, cash flow statements for future years have an element of uncertainty. Different projects may, however, get affected differently from changes in the assumption of cost and return items. Sensitivity analysis helps in finding out that how sensitive is the project to these fluctuations. Sensitivity analysis involves identification of crucial variable relating to costs and returns, specification of alternative values of the crucial variables and re-computation of the NPV and IRR by using the alternative values. A project, which is highly sensitive to even small fluctuations in cost and price, is considered to be a risky project for financing. Risk Analysis Even though through sensitivity analysis and scenario analysis techniques, some of the uncertainties in the project are taken care, both these types of analysis have limitation that they have deterministic values for the variables. In a significant improvement over these methods, under objective risk analysis, probabilistic analysis is done by identification of key risk variables, finding out values of each risk variable, assigning probabilities to each of the risk variables, using these values for risk analysis and finding out the probability of negative outcome of the project, i. e. what is the probability that the NPV of the project will be negative. The risk analysis adds valuable information to the project analysis and it is an important tool in this respect but to take up investment or not depends on the risk taking capacity of the entrepreneur which varies from person to person. Therefore, it is judgmental in nature.