Question

Explain the purpose of and differences between sensitivity and scenario analysis

Thanks

Answer 1

Both Sensitivity Analysis and Scenario Analysis are used to test the model output due to variation in inputs and assess the working of the model under stress/extreme inputs. This is essentially done to assess the risk of the model.

However, Sensitivity analysis is only used to assess the impact of a change in one input at a time on the financial projections/ any other output .i.e. IRR / NPV. Usually, the focus is on changing the critical input on which the model output is most dependent on.

Scenario analysis is used to assess the impact of changes of multiple inputs on the output. It shows the cumulative effect of changes in multiple inputs of the model. All the changes considered together forms 1 scenario.

For ex. each of the projections items can consider a best case, base case and worst case giving rise to 3 scenarios. However, the no of inputs which are changing in each scenario are numerous.