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Applying Sensitivity and Scenario Analysis to a Potential Investment


 

 

What is a sensitivity analysis?

Sensitivity analysis is a measure utilized for the assessment of risk involved in a project. It assesses the impact of different variables on the returns of an investment. It is utilized for the assessment of the impact of the changes in the critical variables, on the project profitability. It renders the data about the estimated project parameters and assists in the estimation of risk and error involved in the project. 

What is a scenario analysis?

Scenario analysis is a measure that utilized for the evaluation of the combined effect of different variables (scenarios). Since the variables involved in an investment are interrelated, there are alters in combination. So, the scenario analysis assists in analyzing the risk associated with different scenarios. It assists the decision makers regarding the consideration of different scenarios and their significance in decision making. 

How would you apply each one to a potential investment opportunity?

We can apply sensitivity analysis as well as scenario analysis to the potential investment opportunities. Both the techniques assist us in evaluating the risk associated with the investment. 

Sensitivity analysis: This technique is useful for the evaluation of the investment on a project. The effect of different variables on the cost benefit ratio, that is NPV or IRR can be effectively evaluated with the assistance of sensitivity analysis. The estimates for each variable is calculated on the basis of three different states of the future value, which are pessimistic, most likely and optimistic. The alterations in the value of NPV (or IRR) can be analyzed by changing the value of one variable. 

Scenario analysis: This technique considers that the variables involved in the estimation of cost benefit ratio are interrelated. Therefore, for the different scenarios, the changes in the NPV or IRR are evaluated by taking the pessimistic, optimistic and most likely values of the variables. The results for each scenario are compared and the most reliable scenario is considered and then the investment is done accordingly. 

The information collected through both the analysis can be utilized for the evaluation of the best possible investment portfolio for the project. In sensitivity analysis, the results provide the uncertainty involved in the investment. The decision of investment is taken according to the reliability of the outcome for a particular variable. In scenario analysis, the results for different scenario provide the uncertainty involved in different scenarios. The decision of investment is taken by considering the most authentic outcome. 

 


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