Scenario analysis is a what-if analysis in which a model's output is calculated for a number of scenarios. Scenario analysis is most commonly used in finance to estimate the expected value of an investment in a number of situations (such as best case scenario, base case scenario and worst case scenario).
Scenario analysis differs from sensitivity analysis in that it allows for changing more than one variables at once while sensitivity analysis measures the effect of change in one variable while keeping all other factors constant. Scenario analysis is quite similar to simulation analysis but less complex because most often it considers only the two extreme and one base case scenarios.
Steps in Conducting Scenario Analysis in Capital Budgeting
Scenario analysis of an investment would involve the following steps:
- Finding the base case output at the most likely value for each input. For example, when calculating net present value, use the most likely value for discount rate, cash flows growth, tax rate, etc.
- Finding the value of the output at the best possible value for each input. In case of calculating net present value, use the lowest possible discount rate, highest possible growth rate, lowest possible tax rate, etc. This is the best case scenario.
- Finding the value of the output at the worst possible value for each input. For a net present value calculation, it would mean the highest possible discount rate, lowest possible cash flow growth rate, highest possible tax rate, etc. This is the worst case scenario.
This gives us a range for output values. In reality, you need not work with extreme scenarios. You can easily set some variables at one extreme, others at the other extreme and some intermediate.
Bolt Inc. is a company that specializes in building tracks for high speed trains in Electrasia. The company is the process of bidding for a new interstate train project. The chief bidding engineer has come up with a net present value estimate of $814.5 million. His inputs include the company's weighted average cost of capital of 8%, cash inflows of $2 billion which are expected at the end of 3rd year, annual expenditures for year 1, 2 and 3 of $300 million per year. You are the chief investment officer and CFO has asked you to conduct a scenario analysis.
Find the best case scenario and worst case scenario.
For the best case scenario, assume a WACC of 6.5%, cash inflows of $2.1 billion at the end of 2nd year and cash outflows of $400 million at the end of 1st year and $500 million at the end of second year. For the worst case scenario, assume a WACC of 9%, cash inflows of $1.2 billion at the end of 4th year and cash outflows of $200 million at the end of each year for 4 years. The initial investment is 0 in all scenarios.
For the best case scenario, the net present value (NPVB) is $1,035 million while for the worst case scenario, the net present value (NPVW) is $202 million.
|NPVB =||-$400M||+||$2,100M−$500M||− 0 = $1,035M|
|(1 + 6.5%)1||(1 + 6.5%)2|
|NPVW = -$200M ×||1 - (1 + 9%)-4||+||$1,200M||− 0 = $202M|
|9%||(1 + 9%)4|
From this scenario analysis, we find that the net present value of the project is expected to be between $202 million and $1,035 million with the most likely figure to be $814.5 million.
Written by Obaidullah Jan, ACA, CFA and last modified on