Sensitivity Analysis and Scenario Analysis in Capital Budgeting

Capital Budgeting is the process by which a Business makes decision on whether to take up a project or not. This involves analysis of the amount of money which is required to invest in the project and the revenue that the project will generate. A business uses various techniques and analysis tools to determine the effects of the various projects. This may involve the calculation of the time taken for the undertaking to produce return to cover the initial contribution, or the amount of cash flow that will be produced from the undertaking totally in its entire span of period along with the amount of profit or loss generated from the same or the break even of the project can be calculated using the discount rate of the project. All the techniques and methods involve making assumptions and making estimations about the future performance of the project. The results derived from the various techniques help the management in decision making. However, the assumptions and estimations so made can turn out to be inaccurate and there may be unexpected results from the project. Sensitivity Analysis and Scenario Analysis are two of the various techniques that provide additional insight for the corporate to make decision regarding investments in various projects.

Sensitivity Analysis and Scenario Analysis

Sensitivity analysis is a methodology which determines how distinct values of a separate variable effect a specific dependent variable under a given kit of assumptions. In different term, sensitivity analysis helps a business to estimate what will happen to the project if the estimates and assumptions turn out to be inaccurate and unreliable. It involves changing one assumption or estimates while the others remaining constant to see the impact on the project finances. Hence, this analysis helps the managers to prepare themselves for against the inaccurate assumptions and unexpected results from the project so that they can make a better analysis before decision making. Sensitivity Analysis is also referred to as “what-if analysis” or “simulation analysis” as it involves the prediction of outcomes under a certain range of variable input. This is done by creating a set of variable inputs and then studying the impact of change in input on the outcome of the project.

This analysis ascertains how the allocation of feasible Net Present Value or the Internal Rate of Return of a project under account is affected sequential to a change in one specific input variable. It begins with base-case scenario which is developed using expected values for each input. Sensitivity Analysis provide the solution for each and every situation that take place if there is any change in variables. For instance estimating the NPV of the project, if the selling price falls by 10%, or determining the Internal Rate of Return if the project life is 3 years instead of the expected life of 5 years. Sensitivity Analysis can additionally be applied to compute the break-even point of the project that is the revenue required to meet the cost in net present value terms.

As mentioned above, each variable is changed by a certain percentage in upward and/or downward direction from the estimated value and keeping the other inputs constant, new Net Present Value is computed. Then all the sets of Net Present Values are plotted on a graph to derive the sensitivity of the NPV to the change in each input. The steeper is the slope of the graph, the more sensitive the Net Present Value is to modify in an input.

The major advantages of Sensitivity Analysis is that it analysis critical issues that impacts the success and failure of the project. Also, Sensitivity Analysis is quite simple and can the results can be derived easily. But along with the advantages, Sensitivity Analysis also carries certain disadvantages. It expects that all elements are separate which is not feasible in reality. Also, it does not take into consideration the probability of changes in the variables.

Although Sensitivity Analysis is the most widely used technique of risk analysis, it contains certain limitations. Therefore, we require to lengthen sensitivity analysis to cope with the probability distributions of the variables. In addendum, it will be more feasible to differ more than one element while so that the blended consequence of changes can be seen. Scenario Analysis provides answer to these situations of expansions. Scenario Analysis brings in the probability of changes in the fundamental elements and also enable changes in excess of one element at a time.

Scenario Analysis is the process of estimating the Net Present Value of the project after a given period of time by assuming specific changes in the values of the key factors that take place in the project. Scenario Analysis starts with the base case or the most likely set of values for the input elements. Then the worst case scenario and best case situation is done. Differently we can say that scenario analysis talks about the badness of a particular project. Scenario Analysis seeks to establish the Best and Worst Scenarios so that the entire scope of results can be taken into account because in practical world, sometimes managers get carried away with the result of the most likely cases and do not consider critical factors.

Scenario analysis looks to be easy although it incorporates certain essential elements. The first element includes ascertaining the element over which the situations will be constructed. Second element is ascertaining the amount of situations to examine each element. Generally, three situations are built being the Best Case, Worst Case and the Average Case or the Most Likely Case. Third element is to put light on essential elements and construct few situations for all elements. Lastly, the assignment of probability to each and every scenario.

Now, lastly it is important to note that sensitivity analysis and scenario analysis are different. Sensitivity Analysis isolates each variable from one another and studies the impact of the possible outcomes on the same. Scenario Analysis on the other hand is based on a situation where all the variables are changed according to scenario to get a comprehensive picture if the situation.

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