138 Financial Management
Scenario Analysis
In sensitivity analysis, typically one variable is varied at a time. If variables are inter-
related as they are most likely to be, it is helpful to look at some plausible scenarios,
each scenario representing a consistent combination of variables.
Procedure
The steps involved in scenario analysis are as follows:- Select the factor around which scenarios will be built. The factor chosen must
be the largest source of uncertainty for the success of the project. It may be the
state of the economy or interest rate or technological development or response
of the market, costs. - Estimate the values of each of the variables in investment analysis (investment
outlay, revenues, cost, project life, and so on) for each scenario. - Calculate the net present value and/or internal rate of return under each sce-
nario.
Illustration
Zen Enterprises is evaluating a project for introducing a new product. Depending
on the response of the market-the factor which is the largest source of uncertainty
for the success of the project-the management of the firm has identified three
scenarios:
Scenario 1: The product will have a moderate appeal to customers across the board
at a modest price.
Scenario 2: The product will strongly appeal to a large segment of the market which
is highly price-sensitive.
Scenario 3: The product will appeal to a small segment of the market which will be
willing to pay a high price.
(Rs. in million)
Scenario 1 Scenario 2 Scenario 3
Initial investment 200 200 200
Unit selling price (in rupees) 25 15 40
Demand (in units) 20 40 10
Revenues 500 600 400
Variable costs 240 480 120
Fixed costs 50 50 50
Deprciation 20 20 20
Pre-tax profit 190 50 210
Profit after tax 95 25 105
Annual cash flow 95 25 105
Project life 115 45 125
Salvage value 10 years 10 years 10 years
Net present value 0 0 0
377.2 25.9 427.4
(at a discount rate of 15 per cent)
Figure 6.7: Present Value Calculation for Three Scenarios