Session 11: Objective 2 - Scenario and Other What-if Analysis (2016)

Summary

This video explains various types of analysis used in evaluating large capital investment projects, focusing on scenario, sensitivity, and simulation analyses. Scenario analysis involves testing three cases (best, base, and worst) to see how changes in volume, price, and costs affect NPV. Sensitivity analysis examines the impact of single variable changes on NPV, particularly volume. Simulation analysis combines the other two, applying random values to variables and calculating numerous NPVs to evaluate multiple outcomes. The video emphasizes the importance of these analyses in decision-making but notes that they cannot directly dictate whether to proceed with a project.

Takeaways

• 😀 Scenario analysis involves evaluating different cases: best case, base case, and worst case, to understand the impact on Net Present Value (NPV).
• 😀 Scenario analysis is commonly used in large capital investment projects to evaluate potential outcomes and avoid analysis paralysis.
• 😀 In scenario analysis, you vary factors like volume, price, and costs (both fixed and variable) to understand how these affect NPV.
• 😀 The best case scenario assumes low costs and high values for price and quantity, while the worst case has high costs and low values for price and quantity.
• 😀 The base case is a middle-ground scenario that represents the most reasonable expectations for the project.
• 😀 A positive NPV indicates that the project should proceed, while a negative NPV means the project should be halted.
• 😀 Sensitivity analysis evaluates how NPV is impacted by changes to one variable, while keeping other factors constant, often focusing on sales volume.
• 😀 The steeper the NPV curve in sensitivity analysis, the more sensitive the NPV is to changes in a particular variable, like sales volume.
• 😀 Sensitivity analysis helps identify which variables require the most attention in project evaluations.
• 😀 Simulation analysis combines scenario and sensitivity analysis to model a wide range of possible outcomes by using random variables and repeating calculations.
• 😀 Simulation analysis provides a broad set of potential NPVs, allowing for detailed statistical analysis (mean, mode, median) but does not make the final decision on whether to proceed with the project.

Q & A

What is scenario analysis, and how does it help in evaluating capital investment projects?

Scenario analysis is a method of evaluating capital investment projects by considering three different cases: best case, base case, and worst case. It helps assess potential risks by varying factors like costs, price, and volume, allowing decision-makers to see how different scenarios affect the project’s financial outcome, particularly the Net Present Value (NPV).

What are the main cases considered in scenario analysis?

The three main cases in scenario analysis are the best case, base case, and worst case. In the best case, costs are low and prices and volume are high. In the worst case, costs (both fixed and variable) are high, and prices and volume are low. The base case lies somewhere in between these extremes.

Why is it important to avoid doing too many scenarios in scenario analysis?

Doing too many scenarios can lead to analysis paralysis, where the decision-making process is hindered due to excessive analysis. It's important to keep the number of scenarios manageable to focus on actionable insights rather than getting bogged down by too many variables.

What is sensitivity analysis and how does it differ from scenario analysis?

Sensitivity analysis is a type of 'what-if' analysis that examines how changes in a single variable, such as sales volume, impact the NPV, while holding all other variables constant. It differs from scenario analysis, which looks at multiple variables simultaneously and compares different cases (best, worst, and base). Sensitivity analysis focuses on identifying the most sensitive variables in the model.

How do you interpret a steep NPV curve in sensitivity analysis?

A steep NPV curve in sensitivity analysis indicates a high sensitivity of the NPV to changes in the variable being analyzed (such as sales volume). The steeper the curve, the more impact small changes in the variable have on the NPV, signaling that this variable requires close attention.

What does sensitivity analysis tell us about a project’s variables?

Sensitivity analysis helps identify which variables most influence the NPV. By understanding which variables have the greatest impact, businesses can focus their efforts on managing those factors to reduce risks and optimize project outcomes.

What is the purpose of simulation analysis in capital investment evaluation?

Simulation analysis combines elements of both scenario and sensitivity analysis. It generates a range of possible outcomes by randomly varying all variables and calculating multiple NPVs. This provides a deeper insight into potential project outcomes, allowing decision-makers to better understand risk and uncertainty.

How has technology impacted the execution of simulation analysis?

With the advent of personal computers and other technology, simulation analysis can now be performed quickly and efficiently. In contrast to the 1980s, when such analyses were done manually and were time-consuming, today’s software allows for rapid calculation of thousands of possible NPVs, making the process much more accessible and practical.

Can simulation analysis tell us whether or not to proceed with a project?

No, simulation analysis does not provide a definitive answer on whether to proceed with a project. It helps in understanding the range of possible outcomes by using statistical methods, but the final decision on whether to take on the project is a judgment call that relies on the decision-maker's risk tolerance and other factors.

What is the primary takeaway from scenario, sensitivity, and simulation analyses?

The primary takeaway is that these analyses are tools to help decision-makers understand the potential range of outcomes for a project. They do not provide a clear-cut answer but offer a deeper understanding of risks and uncertainties, allowing decision-makers to make more informed, strategic choices.