Question

12/07/19

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1. What is the difference between scenario analysis and sensitivity analysis? How might you use each during the capital budgeting process?

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Answer 1

Sensitivity analysis is used in Capital budgeting for more precisely measuring the risk. It helps in assessing information as to how sensitive are the estimated parameters of the project such as cash flows, discount rate, and the project life to the estimation errors. Future being always uncertain and estimations are always subject to error, sensitivity analysis takes care of estimation errors by using a number of possible outcomes in evaluating a project. The methodology adopted in sensitivity analysis is to evaluate a project by using a number of estimated cash flows so as to provide to the decision maker an insight into the variability of outcome. Thus, it is a technique of risk analysis which studies the responsiveness of a criterion of merit like NPV or IRR to variation in underlying factors like selling price, quantity sold, returns from an investment etc.

Although sensitivity analysis is probably the most widely used risk analysis technique, it does have limitations. Therefore, we need to extend sensitivity analysis to deal with the probability distributions of the inputs. In addition, it would be useful to vary more than one variable at a time so we could see the combined effects of changes in the variables. In scenario analysis, Outcomes are computed in scenarios like best case, worst case etc.

So the main difference between sensitivity and scenario analysis is the following

In sensitivity analysis only one variable is altered at a time and change in outcome is observed. But in scenario analysis, more than one variable is altered at a time in order to see the combined effects of changes in the variables.

Example

Let’s say a project having an initial outflow of $ 10,000 generates a projected inflow of $3,500 for 5 years. Discount Rate is 10%, NPV is to be computed to see the viability of the project.

Now in sensitivity analysis, the following analysis can be undertaken

1. Change in NPV when disc. Rate is increased to 15%
2. Change in NPV when the projected inflow per year is reduced to $3000
3. Change in NPV when the life of the project is reduced to 4 years.

While doing scenario analysis, the following scenarios are foreseen.

1. Best case scenario- inflow per year is increased to $4000, Disc rate comes down to 9%, life of the project increases to 6 years
2. Worst case scenario-inflow per year is reduced to $3000,disc rate is increased to 15%, life of the project is reduced to 4 years.
3. Any other combination