Question

Provide an example of a capital budgeting project for an organization with which you are familiar. Explain in detail how you would conduct a scenario analysis and a sensitivity analysis for this project. Explain what information each type of analysis provides that the other does not.

Answer 1

Capital budgeting project of the organisation which will be related to whether to expand the existing division and diversify with expanding it with another product like diversification of automobile manufacturer into automobile ancillaries in order to have a better expansion of the the existing activities and it will be a capital budgeting decision because it is related to long-term and it is also related to a higher amount of cash outflow.

I will conduct a scenario analysis by analysing it through various different perspective of economic scenario and other factors which will be helpful for me in order to find out the overall rate of return in a different scenario, then I will be determining the probability of rate of return difference scenarios like I will expect a recessionary scenario or inflationary scenario And I Will then calculate the present value of the expansion opportunity.

When I will be analysing it through the sensitivity analysis, then I will be using it in respect to a particular independent variable like inflation or interest rate and I will be trying to find out the overall impact of the particular factor on the rate of return of the project so it is a measurement of sensitivity of the project to an independent variable.

Sensitivity analysis and scenario analysis is different because sensitivity analysis is generally related to one situation and one factor according to which changes in the rate of return of the project will be estimated in advance, whereas scenario analysis will be employing a large number of scenario than rate of return which will be earned in different scenarios.