Question

1) what are sensitivity and scenario analysis and be able to distinguish between the two analyses.

Answer 1

Both of them are risk analysis tools and are used extensively in finance in the light of estimation and uncertainity.

As we know various finance models like DDM are dependent upon the inputs which are estimated by us using some statistical techniques or trend analysis. But can we solely rely upon the single point estimate thrown by the model - No. We need to supplement that with sensitivity and scenario analysis ie what will be the effect on final answer if inputs are changed.

For instance , D1 =$24 Required rate of return is 12% and growth rate is 3%, Now as per constant growth DDM, intrinsic value of the share is given by-

IV = D1/(Re-g) = 24/(.12-.03)= 266.67

Now if we change growth rate from 3% to 5%, answer will change to 342.85 - massive change of ( 342.85-266.66)/266.66×100 =28.57%.

So if we change all the three inputs one by one while keeping other two factors constant then it us known as sensitivity analysis as we did above. In this we find out the most critical input which if change slightly can effect output on a massive scale

While on the other hand, scenario analysis changes all the 3 inputs simultaneously and then gives the output. Basically we have three scenarios - optimistic ( everything goes good ie high D1, low Re and high growth - it will give the highest answer), pessimistic (if everything goes wrong ie low dividend, high re and low growth - it will give the lowest answer) and most likely ( which will be intermediate and most likely to happen)