Question

Briefly Explain clearly and concisely as possible

1. When evaluating a capital investment decision, what is the difference between a sensitivity analysis and a scenario analysis? Why are these types of analyses necessary?

2. Give two reasons why a company's cost of equity is always greater than its cost of debt. (Hint: one has to do with risk, and the other with taxes.

Answer 1

Sensitivity analsis measures the change in the single parameter of the model to determine the change and effect that it would have on the outcome. It determines how a outcome and decision varies with changes in the inout variable as well as  how senstive the dependent variable is on the independent variable.It tweaks one variable.

Scenario analysis measures the changes in the all the different inputs at the same time. It changes several independent variables and measures the changes it brings on the outcome in different scanarios. The base case scenario, the best case sceanrio and the worst case scenario.

2. The cost of equity is more riskier than debt as the common shareholders are the residual owners. They will receive what is left after the distribution of the debt holders and the preference share holders.

So, the cost of equity is higher.

The debt holders will have to be paid the interest obligations so the risk is less.

The debt holders enjoy a debt tax shield which the equity holders do not have. The interest paid on debt is tax deductible whereas the dividends paid on equity is not deductible for taxes. So, the cost of debt is cheaper.