Sensitivity analysis in a DCF is used to:
Correct Answer
C) Show how the conclusion moves as key assumptions vary
Sensitivity analysis varies selected assumptions and recalculates the result to show which inputs materially affect value. It can reveal a range of modeled outcomes but does not establish a probability distribution or validate unsupported assumptions. It does not set the assignment’s effective date.
Why This Is the Correct Answer
Option C is correct because sensitivity analysis changes selected assumptions and reruns the model to show how the value conclusion moves. This reveals which inputs drive value and the range of modeled outcomes. It does not by itself validate an assumption or produce a probability distribution.
Why the Other Options Are Wrong
Option A: Calculate the required debt coverage ratio
Option A is wrong because a debt coverage ratio is a lender's underwriting measure comparing NOI to debt service. Calculating a required debt coverage ratio is not the purpose of sensitivity testing in a DCF.
Option B: Determine the property's assessed value
Option B is wrong because assessed value is a figure set for property tax purposes under the taxing jurisdiction's procedures. Sensitivity analysis tests the effect of assumptions on a modeled value; it does not determine assessed value.
Option D: Establish the effective date of the appraisal assignment
Option D is wrong because the effective date of an appraisal is set as part of the assignment's scope and conditions. Varying DCF assumptions has nothing to do with establishing that date.
Wiggle the inputs, watch value
Sensitivity analysis means wiggling one or more key assumptions and watching how much the value moves. Use this to recall that sensitivity analysis is about input-to-output response, not about dates, taxes or loan ratios.
How to use: Use this to recall that sensitivity analysis is about input-to-output response, not about dates, taxes or loan ratios.
Exam Tip
If an answer describes varying assumptions and observing changes in the result, it describes sensitivity analysis. Answers about loan ratios or assessment are distractors from other topics.
Common Mistakes to Avoid
- -Thinking sensitivity analysis proves an assumption is correct
- -Confusing sensitivity analysis with a probability forecast
- -Mixing up DCF testing with lender ratios such as debt coverage
Concept Deep Dive
Analysis
This question tests the purpose of sensitivity analysis in a discounted cash flow model. Because DCF results depend on assumptions like rent growth, vacancy, discount rate and terminal capitalization rate, the appraiser can vary those inputs and recalculate value. The result shows which assumptions materially move the conclusion.
Background Knowledge
The accuracy of a DCF depends on the validity of the assumptions used for its key variables. Sensitivity analysis isolates one or more variables, changes them by plausible amounts and observes the change in value. This helps the appraiser and client understand which assumptions deserve the most support.
Real-World Application
An appraiser valuing an office building runs the DCF with terminal capitalization rates 50 basis points above and below the base case. The value swings noticeably, so the appraiser devotes extra market support to the terminal rate selection.
More Income Approach Questions
Which model describes yield capitalization of property benefits?
An appraiser is valuing a duplex. A market survey of recent duplex sales reports prices at 10.8 times potential gross income, with stabilized vacancy and credit loss of 10% of PGI and no other income. The subject's rent schedule is unavailable, but the property manager's records show collected income of $54,000 a year, in line with market rent and the 10% market loss. What value is indicated?
The subject property is a fourplex with annual EGI of $72,000 and operating expenses of $28,800. Of those expenses, $18,000 is fixed and $10,800 varies in direct proportion to EGI. The owner's annual mortgage payments are $21,000. An appraiser projects that EGI will fall 10% because of higher vacancy. What is the projected NOI?
Annual NOI available for debt service is $168,000 and total annual mortgage principal and interest debt service is $120,000. What is NOI ÷ debt service?
Annual PGI is $250,000 and combined vacancy and collection loss is explicitly 12% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $360,000 and combined vacancy and collection loss is explicitly 8% of that same PGI base. There is no other income. What annual EGI remains?
Annual PGI is $640,000. Combined vacancy and collection loss is 6.25% of PGI. There is no other income. What EGI remains?
An appraiser is updating a prior appraisal of a triplex with potential gross income of $60,000 and no other income. The prior appraisal used vacancy and credit loss of 5% of PGI, and a new survey of competing rentals indicates 8%. The operating expenses of $24,000 are property taxes, insurance and contract services that do not vary with occupancy, and the market overall rate remains 7.5%. By what percentages do effective gross income and indicated value decrease?
Annual potential rental income is $600,000 and vacancy loss alone is $36,000. What percentage of potential rent does that loss represent?
In the subject's market, lenders on fourplexes have lowered their typical loan-to-value ratio from 70% to 60%. The annual mortgage constant remains 5% and the equity dividend rate remains 10%. The subject's NOI has not changed. How does this affect the overall rate indicated by the band of investment and the indicated value?
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