Scenario Analysis: Although sensitivity analysis is probably the most widely used risk analysis technique, it does have limitations. Therefore, we need to extend sensitivity analysis to deal with the probability distributions of the inputs. In addition, it would be useful to vary more than one variable at a time so we could see the combined effects of changes in the variables.
Scenario analysis provides answer to these situations of extensions. This analysis brings in the probabilities of changes in key variables and also allows us to change more than one variable at a time.
Scenario analysis begins with base case or most likely set of values for the input variables. Then, go for worst case scenario (low unit sales, low sale price, high variable cost and so on) and best case scenario.
In other words, scenario analysis answers the question “How bad could the project look”.
Although, the analysis appears to be simple, but it contains four critical components:
1. The first component involves determining the factors around which the scenarios will be built. These factors can range from the state of economy to the response of competitors on any action of the firm.
2. Second component is determining the number of scenarios to analysis for each factor. Normally three scenarios are considered in general i.e. a best case, an average and a worst case. However, they may vary on long range.
3. Third component is to place focus on critical factors and build relatively few scenarios for each factor.
4. Fourth component is the assignment of probabilities to each scenarios. This assignment may be based on the macro factors e.g. exchange rates, interest rates etc. and micro factors e.g. competitor’s reactions etc.
In conclusion, we can say that when we calculate the NPV of several scenarios we are performing a scenario analysis.
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