Question

Explain how sensitivity and scenario analysis can be used as part of capital budgeting investment analysis.

Answer 1

Please build upon the pointers below to develop your answer.

Life is a tissue of contraries. It’s full of risks. In fact it offers more risks than rewards. Same is true with investment decisions. There are various risks associated with capital budgeting such as:

• Variation in future cash flows
• Cost of capital used for discounting can change over the project life
• Estimated project life can be longer or shorter
• Macro-economic environment can be different than projected
• Project feasibility may be compromised due to any regulatory changes or any competitor's strategy or change in trend & taste

Alternative approaches to dealing with risk in capital budgeting

1. Sensitivity Analysis
   1. “What if” technique
   2. Used to determine sensitivity of project cash flows with respect to underlying assumptions.
   3. Project indicators such as NPV, IRR, payback and PI are determined using expected cash flows. Thus sensitivity analysis shows the impact of change in assumption on IRR, NPV and other profitability indicators.
   4. Typical variables or assumptions that are subjected to sensitivity analysis are: sales, sales price, sales volume, variable costs, fixed costs, salvage value etc. Assumption underlying one or two variables are changed at a time, leaving others unchange NPV, IRR, payback and PI are recalculated to determine the effect of changing those assumptions.
2. Scenario Analysis
   1. Scenario analysis is like sensitivity analysis but allows for changes in multiple independent parameters at the same time to show effect on dependent parameter.
   2. A likely probability distribution of independent parameters is considered.
   3. NPV or IRR of a project is analysed under a series of specific scenarios based on macroeconomics, industry specific and firm specific factors. Different scenarios are created such as optimistic, most likely, pessimistic, highly probable, less probable, best case, worst case, base case et NPV and IRR of the project under each scenario are estimated. The decision to accept or reject the project is based on the NPVs and IRRs under all the scenarios, not just one.