Question

What are sensitivity analysis, scenario analysis, break-even analysis, and simulation? Why are these analyses important, and how should they be used?

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Answer 1

Sensitivity Analysis:- Sensitivity analysis is also referred to as 'what-if' or simulation analysis and is a way to predict the outcome of a decision given a certain range of variables. By creating a given set of variables, an analyst can determine how changes in one variable impact the outcome.

Scenario analysis:- Scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes (sometimes called "alternative worlds"). Thus, scenario analysis, which is one of the main forms of projection, does not try to show one exact picture of the future.

THE DIFFERENCE BETWEEN SENSITIVITY ANALYSIS, BREAKEVEN ANALYSIS, SCENARIO ANALYSIS AND SIMULATION ANALYSIS

Sensitivity analysis usually answers’’ what if questions’’ on aspects of the problem that are likely to bring about risk. It enables us to understand effects or changes on the investment value if its key aspects are established and changes on their values effected. It also helps in breaking down the problem so as to facilitate identification of those aspect of the problem that are likely to introduce elements of risk. It is important to note that in real world our predictions are affected by state of nature, Few things would occur than may have been predicted.

There are three states of nature that is Boom, Normal and Recession. In evaluating the risk associated with an asset we usually assign probability levels to these states of nature together with their respective outcomes to find the expected value which would enable us find the standard deviation which is a measure of risk. Although, through the calculation of expected monetary value, risk is explicitly incorporated into the capital budgeting analysis, yet a better insight into the risk analysis will be obtained if we find out the dispersion of cash flows which is the difference between the possible cash flows that can occur and their expected value. The dispersion of cash flow indicates the degree of risk. A commonly used measure of risk is standard deviation. Stated simply, standard deviation measures the deviation or variance about the expected cash flow of each of the possible cash flow. The higher the standard deviation the higher the risk.

If for example we assume a new investment will have the following annual cash flows:

Sales                                           $600,000

Less labour and materials, etc      $250,000

Net   Operating profit                  350,0000

The cost of Initial plant and equipment is expected to cost $800,000 and useful life is 10 years. The cost of capital is 10% and there is no tax to be paid.                 

                        NPV            = $350,000(3.791) -800,000

                                            =$1,326,850-800,000

                                            =526,850

‘’What if’’ there is decrease in sales, an increase in wages and materials and the need to effect change on the project life span. Any of these changes will affect the Net Present Value(NPV) of the investment calculated and also whether it will be embarked on or not. Spread sheet can aid this analysis because once one makes a change in any of the variable automatically a new NPV will be generated. You will have differences in NPVs as the value of the variables are adjusted.

It is important to note that an extension of sensitivity analysis is breakeven analysis which can be used to assess the magnitude of change that will reduce the originally predicted NPV to zero separately for each variable.

Alternatively, the preoccupation of the firm may be in knowing, how far the key parameters could change before the investment becomes unprofitable. This is calculated( assuming 5-year life span) as:3.791X-N800,000=0

X=800,000

        3.791

=N212,026

As long as the cashflow proceeds are greater than N211,026 per year, the investment will have a positive NPV. Alternatively, the firm’s interest may be the time horizon.

N350,000X-800,000=0

X=800,000

     350,000

=2.2857

Looking up 10% annuity-factor from the table reveals that the time horizon is between 2 and 3years.The exact period or year can be found by linear interpolation.

The payback rule implies that investments with the shortest payback period be accepted and in uncertain situations, the shorter investment payback, the less risky is the investment.

Scenario Analysis

When a number of variables are interrelated, then the different combinations can be reviewed as separate possible scenarios. This is called scenario analysis. For example, managers may call for three different but consistent combinations of variables, one is the set of the most optimistic outcomes, another the set of mostly outcome and the third, the set of most pessimistic outcomes. This is called the three-point estimates.

Simulation Analysis

An extension of this approach that calls for a more sophisticated knowledge of probability distributions of outcomes, is called simulation analysis

Break-even analysis:- The break-even analysis lets you determine what you need to sell, monthly or annually, to cover your costs of doing business—your break-even point. The break-even analysis table calculates a break-even point based on fixed costs, variable costs per unit of sales, and revenue per unit of sales.

Simulation analysis:- Simulation analysis is one of the important techniques that are utilized in risk analysis in capital budgeting. Simulation analysis is implemented for preparing a probability profile regarding a criterion of merit by stochastically aggregating the variable values that are associated with the opted criterion.
With the help of sensitivity analysis, the sensitivity of Net Present Value or NPV and IRR or Internal Rate of Return and many other types of criterion of merit to changes in fundamental elements can be ascertained.