Question

Describe the benefits and limitations of both Sensitivity Analysis and Scenario Analysis

Answer 1

Sensitivity analysis
Sensitivity analysis is used to determine how the value of a dependent variable changes when we use various values of an independent variable.

Advantages:
i)In case of sensitivity analysis, a decision maker needs to identify the variables that affects the forecast of cash flows and this helps the decision maker to understand the project in totality.
ii)In helps in identifying the incorrect forecasts and in this way it helps the decision maker to focus on the relevant variables.

Limitations:
i)We cannot expect clear cut results from sensitivity analysis.
ii)We analyze each variable separately in sensitivity analysis, so it doesn't focus on the interrelationship between the underlying variables.

Scenario Analysis
Scenario analysis is a technique used to calculate the value of an investment by taking into consideration a variety of scenarios or future possibilities like worst case scenario, average case scenario and best case scenario.

Benefits:
i)Scenario analysis helps in business decision making as it takes into account possible future events in the business.
ii)It helps in developing mitigation strategies and also contingency plans in case of insurers or insurance companies.
iii)Using scenario analysis we can have a range of values that will refer to the how much the stock value will be under various scenarios.

Limitations:
i)It cannot measure accurately the by products of major factor movements (factors of production, movements of labor, capital etc)
ii)Scenario analysis depends heavily on the quality of the model, the quality of the data used for scenario analysis, and the quality of the team working on scenario analysis. For example, if the data quality is poor, the result will mostly be incorrect and also unreliable.
iii)Scenario analysis needs continuous revision, control and refinement by a group of experts.
iv)The outcome sets in a scenario analysis will be bounded by the values of extreme events which can be both positive and negative events.